Since 2008, banks have increasingly extended loans to corporations based on the borrower’s credit default swap (CDS) spread, and according to research by the Federal Reserve Bank of New York this market-based pricing could lower the cost of bank credit.
Such loans tie the interest-rate spread to the borrower’s CDS spread or to a credit derivative index over the life of the loan, according to João A. C. Santos, vice president of the New York Federal Reserve’s statistics group.
“Market-based pricing (MBP) has the potential to lower the cost of bank credit because it saves on [banks’] monitoring costs,” Santos said in a blog post on Tuesday. Those costs include the expenses incurred to screen borrowers for credit quality and to “follow borrowers during the realization of their investment,” says Santos. Lower pricing could also result because MBP protects banks against increases in borrowers’ default risk, he says.
By no means has this kind of loan taken off. Since the second-quarter of 2008, about one-third to one-half of investment-grade bank loans in the syndicated loan market have been CDS/CDX-based loans. “Banks have used market-based pricing predominantly on loans to large corporations,” Santos says. “Even though the number of CDS/CDX-price-based loans issued per quarter rarely exceeds 20, the amount of total debt issued under these contracts has been as high as $95 billion per quarter.” (See chart on total MBP lending.)
While these loans often often include an interest-rate cap or floor, Santos and his fellow researchers found that banks charge lower interest rates at origination when they tie loan spreads to borrowers’ CDS spreads. He attributes this to the cost savings mentioned above. Notably, “banks do not seem to use the CDS market extensively to lay off credit risk,” says Santos. That’s good, because positions in credit derivatives are what caused JP Morgan billions in trading losses.
Tying corporate CDS spreads to bank loans definitely has other hazards, however. The most severe: the potential to cause 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,” which, as bankers know, leads to “further increases in borrowers’ CDS spreads and another wave of increases in the cost of bank credit,” says Santos.