Credit Default Swaps (CDSs) enable lenders to distribute credit risk to parties more willing and able to bear it, thereby enhancing the liquidity and flexibility of individual lenders and the financial system (Greenspan 2004). However, empirical evidence suggests that CDSs lead to a significant decline in the rigor and efficiency of monitoring by lenders (e.g., Ashcraft and Santos, 2009; Parlour and Winton 2013; Subrahmanyam, Tang, and Wang 2014). In our paper, “Credit Default Swaps and Managers’ Voluntary Disclosure,” we predict and find that CDS reference firms enhance their voluntary disclosure to offset the negative effect of reduced lender monitoring.
Since shareholders cannot effectively delegate monitoring to CDS-protected lenders, we expect them to increase their information acquisition for the purpose of monitoring managers. Shareholders, however, lack access to the private information available to lenders and therefore primarily rely on public disclosures for monitoring. Based on prior findings that voluntary disclosure facilitates shareholder monitoring of managers, we hypothesize that managers respond to shareholders’ information demand by increasing voluntary disclosure.
We focus on management earnings forecasts, an important voluntary disclosure choice. We find that CDS firms are more likely to issue management forecasts than are non-CDS firms. Economically, CDSs increase the likelihood of a management forecast by 6.4 percent, a 19.1 percent increase over the unconditional forecast likelihood of 33.5 percent. We reaffirm this finding by showing that CDS availability is also strongly associated with the frequency of management forecasts; the average forecast frequency of CDS firms is 35.6 percent higher than that of non-CDS firms. These findings are consistent with our prediction that reduced lender monitoring due to CDS availability leads shareholders to intensify their monitoring efforts and demand enhanced public disclosure.
To identify the mechanism through which CDSs affect disclosure, we next examine factors that may affect the intensity of lender monitoring or shareholder response. First, we expect the reduction in lender monitoring to be more pronounced when lenders have higher ability and propensity to hedge credit risk using CDSs. As CDS liquidity makes hedging easier and cheaper, we find a stronger effect of CDSs on the likelihood and frequency of management forecasts for firms with more liquid CDSs. We also argue that banks with larger credit derivative positions in general are more likely to use CDSs to hedge their credit exposures. We find some supporting evidence that the effect of CDSs on voluntary disclosure is stronger when the firm’s loans are issued by banks more active in the credit derivatives market.
Second, we expect the reduction in lender monitoring due to CDSs to be more pronounced when lenders have weaker monitoring incentives. Requiring the lead arranger of a syndicate to have more “skin in the game,” i.e., a greater share of the loan, increases the lead arranger’s incentives to monitor the borrower. Consistent with this prediction, we find that the effect of CDS availability on the likelihood and frequency of forecasts is higher when lead arrangers retain smaller loan share. We also expect the monitoring incentives of CDS-protected lenders to be weaker for firms with higher distress risk, because lenders’ reputational loss in case of a borrower’s default or underperformance is likely lower when the probability of financial distress is higher. Our evidence shows that the effect of CDS availability on earnings forecast disclosure is significantly stronger for firms with higher financial distress risk. Further, we expect weaker monitoring when loan contracts include a smaller number of financial covenants, which typically serve as tripwires that endow lenders with control rights when a borrower’s performance deteriorates. Consistent with this prediction, we document a higher level of voluntary disclosure for CDS firms with fewer financial covenants in their loan contracts.
Third, we explore settings that are likely to be associated with stronger shareholder response to reduced lender monitoring. Demand for information most likely arises from sophisticated investors that are aware of CDS availability on their investee’s debt and influential enough to affect corporate disclosure policies. We therefore predict that these investors demand greater disclosure when lenders reduce their monitoring intensity due to CDSs. Consistent with our prediction, the positive association between CDSs and voluntary disclosure is more pronounced for firms with higher institutional investor ownership. Relatedly, we show that the effect of CDSs on management forecast activity is higher for firms with stronger corporate governance, a proxy for which is board independence, consistent with independent directors protecting shareholder interests by demanding enhanced voluntary disclosure when lenders reduce their monitoring intensity due to CDS availability.
Our paper sheds light on how changes in capital markets affect managerial disclosure. Our results suggest that CDS firms enhance voluntary disclosure to mitigate the negative effects of reduced monitoring by CDS-protected lenders. Our findings thus highlight that the negative consequences of a new financial innovation must be evaluated in light of the totality of its related effects on firms and their stakeholders.
This post comes to us from professors Jae B. Kim at Lehigh University’s College of Business & Economics, Pervin K. Shroff at the University of Minnesota’s Carlson School of Management, Dushyantkumar Vyas at the University of Toronto, and Regina Wittenberg Moerman at the Marshall School of Business of the University of Southern California. It is based on their recent paper, “Credit Default Swaps and Managers’ Voluntary Disclosure,” published in the Journal of Accounting Research and available here.