The most recent European debt crisis highlighted the strong interconnection between sovereigns and banks and the various transmission channels that may trigger the contagion of credit risk among both. Governments directly or indirectly protected or even bailed out distressed financial institutions at the expense of increasing sovereign credit risk. This, in turn, induced intensifying feedback loops, also called ‘diabolic loops’ by some authors (see Singh et al., 2016), by eroding the value of banks’
government guarantees and significant amounts of sovereign debt, as recently observed (Gross and Kok, 2013; Acharya et al., 2014; Alter and Beyer, 2014). These
‘diabolic loops’ typically arise in times of crisis or may even be the reason for a crisis (Alter and Beyer, 2014; Poon et al., 2017). Additionally, the role of credit rating agencies has been subject of numerous debates, as was the case prior to the European debt crisis. Against the background of the U.S. subprime crisis and global banking crisis, it is argued that on the one hand, rating assessments referring to asset-backed securities did not reflect the true asset quality of those instruments and thus stimulated the global impact caused by the collapse of the asset-backed securities market. On the other hand, frequent sovereign rating assessments during crisis periods are assumed to exacerbate current problems and force policy makers to take additional actions to stabilize financial markets. In any case, in modern financial markets, credit ratings are commonly accepted as providing a professional and allegedly independent appraisal of the creditworthiness of a debtor. Especially in the case of sovereign ratings, credit ratings address the specific default risk of national governments. Consequently, due to their general importance for investment decisions, changes in credit ratings – and thus in perceived creditworthiness – should have effects on financial markets.
Four main transmission channels have been identified that may trigger contagion of sovereign credit risk to banks (Committee on the Global Financial System, 2011).
Although these channels have been investigated by several researchers who focused
on domestic banks (see, e.g., Bruyckere et al., 2013; Mink and Haan, 2013; Alter and Beyer, 2014; Correa et al., 2014; Caselli et al., 2016), empirical evidence on spillover effects on foreign banks in particular is rather scarce. Furthermore, although banks’
exposures to sovereign debt are usually home-biased (Committee on the Global Financial System, 2011), in some cases, banks might hold relevant amounts of foreign sovereign debt to make use of asset diversification benefits; hence, they are exposed to market-wide events and systematic risk (Baele et al., 2007) and foreign asset holdings might represent a serious source of international spillover effects. To fill this research gap, we propose three research questions that we want to answer in this paper. First, do sovereign rating assessments spill over to foreign banks’ stock prices more severely than to foreign markets in general? Second, how important is the role played by banks’ foreign asset holdings in the transmission of spillovers from sovereign rating assessments to foreign banks? Third, is the importance of foreign asset holdings amplified by the magnitude of the shock in the event country?
In the context of evaluating the systemic risk of the whole financial system, we believe these to be important issues due to the ongoing globalization and interconnection of financial markets.
We apply traditional event study methodology to a sample of 23 member countries of the Organization for Economic Co-operation and Development (OECD) from 1983 to 2014 to test the effect of sovereign rating events, particularly on foreign (non-event) country bank stock returns. The four main transmission channels that have been verified, at least for domestic banks, give rise to multiple ways of triggering the contagion of sovereign credit risk to banks. Consequently, although studies such as Chen et al. (2016) show that sovereign ratings also affect economic growth, we expect that banks are more exposed to sovereign credit risk than are non-financial firms in general, as non-non-financial firms do not face all spillover channels.
Hence, we investigate abnormal returns of banks using a (risk-adjusted) market model to see whether spillover effects on banks are stronger than on general stock market indices. Then, we use the panel structure of our dataset and integrate abnormal bank returns into a double fixed effect regression model to investigate both the importance of the foreign asset holdings and whether the strengths of spillovers increase with the severity of the event. We find evidence that negative sovereign
rating events induce spillovers to foreign banks and that these effects are more severe if banks in the non-event country hold larger assets in the event country. An increase in banks’ foreign exposure in the re-rated country leads to more negative abnormal returns in the case of a negative foreign sovereign rating assessment. Furthermore, the impact of foreign asset holdings significantly increases along with the severity of the rating event, and the economic effect is huge, as a one-standard-deviation increase in foreign claims leads to a decrease in abnormal returns of more than 54%
of the CAAR’s standard deviation of banks. This finding is robust both to various model specifications and to differing sample periods or return country sample compositions. However, we find that our results are not similarly valid for rating upgrades.
Our research contributes to the existing literature, which we describe in detail in the following section, in three important ways. First, a plurality of studies investigating spillover effects of sovereign ratings look at the stock market reaction in general (see, e.g., Kaminsky and Schmukler, 2002; Brooks et al., 2004; Ferreira and Gama, 2007; Li et al., 2008; Bissoondoyal-Bheenick, 2012; Fatnassi et al., 2014), while we specifically investigate bank stock returns. Bank stock returns are even of greater importance than general stock markets because of banks’ role in financial stability and financial soundness. Second, to the best of our knowledge, we are the first to directly test whether banks’ foreign asset holdings are a relevant factor for the strength of stock market spillovers. We investigate this transmission channel directly, which we expect to be relevant because of banks’ international investment activity.
Previous literature on spillovers in financial markets has not found portfolio investments to significantly determine the size of the spillover (see, e.g., Gande and Parsley, 2005; Ferreira and Gama, 2007). In banking, however, Poon et al. (2017) have shown that European banks have higher rating downgrade likelihoods with more exposure in GIIPS countries (Greece, Ireland, Italy, Portugal and Spain). We add to their analysis by showing that bank stock returns are also affected and by finding that the spillover effects are not limited to European countries. Even when excluding GIIPS countries, the effect is substantial. Third, we are the first to test whether the strength of the transmission is moderated by the size of the shock in the event country. To model the shock, we consider not only rating changes in the event
country but also a very direct measure, namely, event-country banks’ stock market reaction to rating changes. We analyze a broad and worldwide sample of OECD economies during a long sample period of more than thirty years, covering several financial and economic crisis periods.
The remainder of our paper is structured as follows. Section 3.2 reviews the existing literature concerning the effects of sovereign rating events on financial markets and develops our hypotheses. Section 3.3 introduces the main data used in our study and provides descriptive statistics regarding our sample countries. Section 3.4 discusses the foreign banks’ stock market reactions to sovereign rating events and investigates the role of banks’ foreign asset holdings in international spillover effects. We critically review our results by performing a series of robustness tests and provide some extensions of our analysis in section 3.5 before concluding the paper in section 3.6.