In the runup to the devastating financial crisis of 2008, credit default swaps—a complicated derivative product that in essence offers lenders some protection against borrower credit risk—enjoyed exponential growth.

Even though the reputation of credit default swaps, or CDSs, took a major hit with the financial crisis, they remain an almost $10 trillion market. Why? Lenders value the protection that having a hedge against credit risk provides. And in the wake of the financial crisis, regulations governing CDSs in the United States have been tightened considerably, becoming more clear, strict, and standardized. Plus, the trading process has become more transparent.

Clearly, CDSs are one of the most significant financial market innovations in recent times. But they remain controversial. Prior research suggests lenders are less likely to closely monitor CDS reference entities than they would be if they didn’t have what, in effect, is insurance against the risk of debt default.

And that makes some intuitive sense. After all, without CDS protection, lenders have strong incentives to rigorously and efficiently monitor borrowing companies to make sure they can meet their interest and principal obligations. However, lenders with CDS contracts make money even if those borrowing companies go bankrupt.

But that doesn’t tell the whole story. When looking at innovative financial products, you need to look at the totality of the related effects they have on firms and their stakeholders.

Boosting Voluntary Disclosures

Over the past decade, much of my research has focused on the area of firm disclosure. So when researchers from other institutions were exploring various aspects of CDSs, they asked me to join them in looking at the effects that CDSs have on voluntary disclosure choices that companies make.

What we discovered is that when lenders let down their guard on monitoring, shareholders often step up, demanding more information from company managers. The result, as our study reported, is that “firms with CDS contracts are more likely to voluntarily disclose and to disclose more frequently via management earnings forecasts.”

What’s more, we found “that mangers are more likely to issue earnings forecasts and forecast more frequently when lenders have a higher ability and propensity to hedge credit risk using CDSs, and when lender monitoring is weaker. In addition, the effect of CDSs on voluntary disclosure is strong when shareholder demand for disclosure is greater.”

In other words, shareholders compensate for the CDS-related reduction in lender monitoring by demanding more information, which in turn prods managers to enhance voluntary disclosures.

The study I co-authored with Pervin Shroff, University of Minnesota; Dushyantkumar Vyas, University of Toronto; and Regina Wittenberg Moerman, University of Southern California, was published in the Journal of Accounting Research and recognized as a top 20 most read paper in 2018.

Monitoring the Managers

The widely held assumption before our study was that CDSs may not be good for shareholders because lenders had diminishing incentives to monitor borrower credit risk as rigorously and efficiently as they would without the protection against debt default that CDSs provide. So managers may take more risks that are not in the best interests of shareholders.

But that assumption did not take into account the important role played by engaged shareholders. By demanding more information from managers, shareholders can evaluate whether the managers are making sound decisions.

If lenders don’t monitor their borrowers as rigorously as they should, shareholders will monitor the managers of borrowing firms.

This example underscores why it’s necessary to look at the totality of effects to understand the positive and negative consequences when evaluating financial innovations. That’s a lesson that legislators and investors would do well to bear in mind.

Jae Bum Kim

Jae Bum Kim

Jae Bum Kim, Ph.D., is an associate professor in the Department of Accounting at Lehigh Business.