The authors find that changes in sovereign credit ratings strongly affect banks’ credit ratings in emerging markets, as do ownership structure, economic freedoms, and macroeconomic conditions.
The authors attempt to determine the degree to which sovereign credit rating actions affect the credit ratings of banks in emerging markets. They investigate the sensitivity of banks’ credit ratings to the rating upgrade, downgrade, or change in the watch status of sovereigns. They also analyze the effects of country characteristics, macroeconomic conditions, and bank ownership.
How Is This Research Useful to Practitioners?
A country’s credit rating generally caps or constrains the achievable rating of nonsovereigns in the country (the sovereign ceiling). This phenomenon is very much alive in emerging market banking systems. The authors analyze ratings data for 425 banks in 54 emerging market countries across three different credit rating agencies (CRAs), accounting for such qualitative factors as the countries’ degree of financial freedom and economic well-being. They find that sovereign rating upgrades and downgrades exert a strong influence on the credit ratings of banks in emerging markets. The effect is fairly strong across different bank ownership structures, although it appears to be the most pronounced for local privately owned banks (most sensitive to sovereign upgrades) and foreign-owned banks (most sensitive to downgrades). Their analysis incorporates robustness checks on subsamples divided by CRA, bank ownership, and time periods to confirm the consistency of the overall results. Of note, they find differences in the pre- and post-crisis periods.
How Did the Authors Conduct This Research?
The authors review the relevant literature on bank ratings, rating heterogeneity, and the market impact of sovereign rating actions, noting the absence of any previous research analyzing a link between bank ratings and sovereign rating actions. A brief discussion of credit rating migration provides a useful context for the parsing of data that evaluate how outlook and watch status affect ratings of sovereigns and, by extension, banks in emerging markets. Finally, they explore the influence sovereign credit ratings have on financial market dynamics and the cost of capital, noting rating information’s effect on international banking, foreign direct investment, and portfolio flows. This information is also useful in the discussion of sovereign rating actions’ influence on banks.
The authors use end-of-month long-term foreign currency ratings for sovereigns and banks in 54 emerging market countries. The ratings data are taken from the InteractiveData Credit Ratings International Database. They also use macroeconomic data from the IMF, the World Bank, and Oxford Economics (as provided by DataStream). Emerging market banks rated by at least one of the three CRAs—Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings—are selected for data covering the period 30 November 1999–31 December 2009. They choose bank rating actions that occur no more than three months after the rating change for the sovereign to avoid contamination of the sample by other factors and to account for the CRAs’ expression of an ex ante target of 90 days to take action once an issuer is placed on watch. The final sample contains a total of 1,750 observations among all three CRAs.
Country characteristics form the other explanatory variables. Using the Heritage Foundation’s Index of Economic Freedom, the authors rank emerging markets by the degree to which they afford economic freedom across the domains of open markets, limited government, regulatory efficiency, and rule of law.
The authors use an ordered probit modeling approach to evaluate the impact of sovereign ratings on bank ratings, a widely accepted practice in credit ratings literature. The model estimates the probabilities of an upgrade, a downgrade, or no rating change for bank credit ratings. The authors use additional models to parse the data further to determine the effects of country characteristics and economic factors on bank rating sensitivity to sovereign rating changes.
Bank analysts who research emerging markets would do well to augment their research of individual banks with research of the bank’s country. Both positive and negative sovereign credit ratings changes affect a bank’s credit ratings. A country’s cost of capital flows through to the economy and, in particular, to the banks that provide funding for commerce in the country. Indeed, a nation’s banking system is a function of the nation’s economic well-being or malaise. This lesson should not be lost on policymakers and analysts in advanced economies struggling with monetary and fiscal issues.