Abstract
We develop a model to analyze the effects of credit protection (e.g., credit insurance, guarantees, credit default swaps) on the provision of incentives to borrowers. Credit protection insulates lenders against losses when liquidating non--performing borrowers' projects. This hardens borrowers' budget constraints, which can have positive implications for incentives. However, credit risk transfer also dilutes the joint surplus of the bank-borrower coalition, thereby making it less worthwhile to implement high effort. The tradeoff between the costs and benefits of risk transfer has implications for the optimal design of credit protection vehicles.
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