| The development of new financial markets is often viewed as unambiguously beneficial, because market efficiency is improved by the offering of new financial securities that span all possible state space opportunities. In this paper, I show that this may not be the case if the introduction of a new market undermines the operation of an existing one. I examine the bank loan market in a world with fairly priced credit derivatives. I show that in a single period setting, the introduction of credit derivatives markets undermines the monitoring equilibrium in the bank loan market and induces banks to shirk. Subsequently, I show that banks' incentives to monitor loans are restored in a multi-period setting, where banks extract high rents by developing reputations as active monitors. However, since bank monitoring is unobservable, the resulting reputation equilibrium is not stable as banks build and burn their reputations over time. |
