Credit Derivatives Increase the Cost of Borrowing

That's the counterintuitive finding from a new working paper from economists at the New York Fed. And it's all about incentives.

But first, why should credit derivatives lower the cost of borrowing in the first place?

Well,

     - The opportunity to diversify risk helps banks use their capital more efficiently, and this added efficiency could be passed on to borrowers, the researchers say.

     - When banks lend to a business, they gain information that's not readily available to most investors. Banks can spread this information through their actions in the CDS market. This could reduce the cost of borrowing by cutting into the "information premium" that investors put on a business's bonds since that information is now available in the CDS market.

But there is also a downside for businesses: In buying protection against a default through the CDS market and protecting its rear end, the bank reduces its own incentive to actually monitor those loans, which could send borrowing costs for that business higher.

It turns out that this negative effect outweighs the positive ones for firms that have higher credit risk or are more "informationally opaque".

This happens, the researchers argue, because in a syndicated loan (a loan with many banks involved), the lead bank can hedge the loan's risk through the CDS market without the knowledge of outside lenders, which could lead to an increase in loan interest rates.

All the news isn't bad, however, as there is a small positive effect on borrowing costs for safer and more transparent firms. But overall, the impact of the CDS market seems to be that it increases the cost of debt issuance.

The researcher's proposed solution? Regulation.

"Regulators might consider requiring a lead bank in a syndicate to disclose any hedges of retained positions to outside investors. It seems possible that such disclosures would improve outcomes for everyone, including those of the borrower, by mitigating concerns that the lead bank does not have the proper incentives."