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Playing Hardball: Relationship Banking in the Age of Credit Derivatives

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  • Stefan ARPING,

    (University of Lausanne)

Abstract

This paper develops a contracting framework in order to explore the effects of credit derivatives on banks’ incentives to monitor loans, their incentives to intervene, and, ultimately, borrowers’ incentives to perform. We show that (i) credit derivatives with short term maturity strengthen incentives to intervene, incentives to monitor, and managerial incentives to perform; (ii) while credit derivatives with long term maturity weaken incentives to intervene, intervention incentives can be maintained by sourcing more short term credit insurance; (iii) long term credit insurance nevertheless weakens managerial incentives through a dilution effect. These findings suggest that properly designed credit derivatives strengthen monitoring incentives and result in efficiency gains, rather than impeding economic efficiency.

Suggested Citation

  • Stefan ARPING,, 2002. "Playing Hardball: Relationship Banking in the Age of Credit Derivatives," FAME Research Paper Series rp49, International Center for Financial Asset Management and Engineering.
    • Handle: RePEc:fam:rpseri:rp49
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    File URL: http://www.swissfinanceinstitute.ch/rp49.pdf
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    References listed on IDEAS

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    Cited by:

    1. Parlour, Christine A. & Winton, Andrew, 2013. "Laying off credit risk: Loan sales versus credit default swaps," Journal of Financial Economics, Elsevier, vol. 107(1), pages 25-45.

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