- The Transformation of Banking: Tying Loan Interest Rates to Borrowers' Credit Default Swap Spreads （Federal Reserve Bank of New York）
It appears that banks are able to lower the cost of credit because of the savings they realize by replacing costly screening and monitoring with borrower-specific information from CDS markets. We draw this conclusion because we find that loans with market-based pricing have fewer covenants than otherwise similar contracts with fixed interest rate spreads.
The adoption of market-based pricing, by reducing banks' monitoring, might also have a negative effect on investors that free ride on bank monitoring, and consequently on the cost of non-bank funding sources.
Further, market-based pricing has the potential for creating spirals in the cost of bank credit. Adverse shocks to the CDS market could lead to an increase in the cost of bank credit, putting pressure on the financial condition of borrowers. This outcome could, in turn, lead to further increases in borrowers’ CDS spreads and another wave of increases in the cost of bank credit.