The impact of sovereign credit rating changes on the european financial system

Abstract

We aim to assess the impact of sovereign credit rating changes on the European financial system. In particular, we analyze the impact of a sovereign rating change on: the sovereign CDS market, the cost of syndicated loans, and the activity of domestic banks. In the first chapter, we analyze the impact and the spillover effect of a sovereign rating announcement on the euro area CDS market. We show that downgrades and upgrades considerably affect financial markets. The relevance of the impact is due to the introduction of “new” information after a rating change announcement and to the role of rating in the current financial regulation. Conversely, the CDS market does not seem to react significantly to rating warning (outlook and review) announcements. Furthermore, we find evidence of a spillover effect only after a downgrade announcement. In the second chapter, we analyze the impact of sovereign rating changes on European corporate loan spreads. We demonstrate that sovereign downgrades lead to significant increases in the spread of loans to domestic firms. We find evidence that the negative effects of a sovereign downgrade are widespread across all firms, also unrated. A relevant part of this impact depends on the reliance of financial regulation on credit ratings (certification effect), which reduces also loan size and leads to additional burdens for investment grade firms. Instead, we do not find evidence of a significant impact generated by an upgrade. In the third chapter, we verify the effects of sovereign rating revisions on the activity of European banks, in terms of their regulatory capital ratio, profitability, liquidity, and lending supply. First, we find that a sovereign downgrade has a IV significant impact, primarily on capital ratios and lending supply. In contrast, upgrades do not have a significant impact, indicating an asymmetric effect of sovereign rating changes. Second, we find that three transmission channels (assets channel, funding channel, and rating channel) explain a relevant part of the impact of a sovereign downgrade. Finally, we find strong evidence that the ratingbased regulation affects all measures of the activity of domestic banks, causing negative externalities for financial institutions.