Credit protection and lending relationships

We examine the impact of credit default swaps (CDS) on lending relationships and credit market efficiency. CDS insulate lenders against losses from forcing borrowers into default and liquidation. This improves the credibility of foreclosure threats, which can have positive implications for borrower incentives and credit availability ex ante. However, lenders may also abuse their enhanced bargaining power vis-à-vis borrowers and extract excessive rents in debt renegotiations. If this hold up threat becomes severe, borrowers will be reluctant to agree to debt maturity designs or control rights transfers that would have been optimal in the absence of CDS markets. The introduction of CDS markets may then ultimately tighten credit constraints and be detrimental to welfare. Our analysis yields a number of empirical implications, some of which have been tested.

► We examine the impact of credit default swaps on lending relationships. ► CDS insulate lenders against losses from letting borrowers fail. ► This improves the credibility of foreclosure threats, which can have positive implications for borrower incentives ex ante. ► However, lenders may also abuse their enhanced bargaining power and extract excessive rents in debt renegotiations. ► If this hold up problem becomes severe, the introduction of CDS markets will ultimately tighten credit constraints.