Sovereign credit risk, banks' government support, and bank stock returns around the world

Abstract: Banking crises have been largely associated with la rge output and welfare losses, and bank bailouts by the public sector are a recurring feature of financial crises. Such stylized facts underscore the importance of a well- functioning financial system for attaining economic stability and growth, as well as the relevance of understanding the relationship between the economic conditions fa ced by the government and the banking sector. In particular, differences and cha nges in explicit (and implicit) government support to banks may affect investors’ i ncentives to hold bank stocks, and thus impact banks’ external financing costs, wh ich may send ripples through the rest of the economy. Similarly, sovereign debt rat ing changes may unveil new information about a country’s fundamentals, generat ing a significant externality for the country’s banking system, and thus they also af fect investors’ incentives to hold bank stocks. We explore the joint impact of sovere ign debt rating changes and government support on bank stock returns from 36 countries between 1995 and 2011. Our findings show that sovereign rating chan ges have a significant and robust impact on bank stock returns. The impact is nonlin ear and varies across banks and countries. Moreover, we find that the effect is as ymmetric and stronger for downgrades than for upgrades, and that large downgr ades have a particularly strong negative impact on returns. Importantly, this resu lt is significantly stronger for banks with more ex-ante government support, providing evidence that investors perceive sovereigns and domestic banks as markedly interconnected.

Figures

Table 4 Determinants of government support of banks

Table 8 Robustness checks

Table 7 Sovereign ratings events, government support, own-sovereign debt holdings, and banks’ excess

Table 6 Sovereign ratings events, government support, and banks’ excess returns

Table 11

Table 10 Sovereign ratings events, government support, banks’ excess returns, and bank characteristics

Full text

Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Number 1069
December 2012
Sovereign Credit Risk, Banks’ Government Support, and
Bank Stock Returns around the World
Ricardo Correa
Kuan-Hui Lee
Horacio Sapriza
Gustavo Suarez
NOTE: International Finance Discussion Papers are preliminary materials circulated to
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at www.ssrn.com.

Sovereign Credit Risk, Banks’ Government Support, and Bank Stock
Returns around the World
RICARDO CORREA
Federal Reserve Board
KUAN-HUI LEE
Seoul National University Business School
HORACIO SAPRIZA
Federal Reserve Board
GUSTAVO SUAREZ
∗
Federal Reserve Board
December 20, 2012
Abstract
We explore the joint effect of expected government support to banks and changes in
sovereign credit ratings on bank stock returns using data for banks in 37 countries
between 1995 and 2011. We find that sovereign credit rating downgrades have a
large negative effect on bank stock returns for those banks that are expected to
receive stronger support from their governments. This result is stronger for banks in
advanced economies where governments are better-positioned to provide that
support. Our results suggest that stock market investors perceive sovereigns and
domestic banks as markedly interconnected, partly through government guarantees.
Keywords: sovereign bond, credit rating, bank stock returns, government guarantees
JEL Classification: G21, G24, H63, G14
∗
The views in this paper are solely the responsibility of the authors and should not be interpreted as
reflecting the views of the Board of Governors of the Federal Reserve System or of any other person
associated with the Federal Reserve System. For very useful feedback that greatly improved the paper, we
very grateful to Jakob de Haan, an anonymous referee, and Reint Gropp (the discussant at the Post-Crisis
Banking Conference organized by the Dutch Central Bank, the European Banking Center, and the
University of Kansas School of Business). For useful comments, we also thank Chris Karlsten, Stijn
Claessens, Eric Engstrom, Juan Carlos Hatchondo, Jean Helwege, David Mayes, Dror Parnes, and seminar
and conference participants at the International Monetary Fund, the Federal Reserve Board, the Post-Crisis
Banking Conference in Tilburg, the Federal Reserve Bank of Richmond, and the 2012 meetings of the
Midwest Finance Association, the Financial Management Association, the International Banking,
Economics, and Finance Association, and the Southern Finance Association. We also thank Hal Baseman
and Sarah Hirsch for excellent research assistance.
Ricardo Correa is a senior economist at the Federal Reserve Board (Ricardo.Correa@frb.gov),
Kuan-Hui Lee is an assistant professor of finance at the Seoul National University Business School
(kuanlee@snu.ac.kr), Horacio Sapriza is an economist at the Federal Reserve Board
(Horacio.Sapriza@frb.gov), and Gustavo Suarez is a senior economist at the Federal Reserve Board
(Gustavo.A.Suarez@frb.gov).

1
1. INTRODUCTION
The ongoing global financial crisis has strongly highlighted that investors believe
that banks are closely connected with their governments. Both governments and banks
are typically very dependent on domestic economic activity, which affects tax revenues
and the demand for financial services. In addition, banks tend to hold significant
volumes of domestic sovereign debt on their balance sheets, which implies that the
creditworthiness of the government directly impacts the asset quality of the banking
sector. Moreover, and perhaps the subject of the most intense political debate in recent
years, many investors expect governments to support troubled domestic banks, as
widespread bank failures may adversely affect economic activity.
In this paper, we study the connection between banks and governments by
focusing on bank stock returns after sovereign rating changes, relatively discrete events
that signal changes in the financial conditions of governments. More importantly, we
exploit cross-sectional variation in the stock market response of banks to sovereign rating
changes to better understand the transmission mechanism that operates from the fiscal
situation of the government to the financial health of the banking sector. In other words,
we are interested in understanding why stock market investors believe that banks are
connected with their governments. Studying stock price reactions to discrete events like
sovereign rating downgrades allows us to focus on a tight window during which fewer
spurious factors are likely to explain the connection between the health of the banking
sector and the fiscal situation of the government.

2
To study the stock market reaction to sovereign rating changes, we first identify
314 sovereign rating changes that affected the debt issued by governments in 37
developed and emerging economies from 1995 to 2011 using ratings data from Standard
& Poor’s Ratings Services (henceforth, S&P). We next collect data from
Datastream/Worldscope and Moody’s Investors Service (henceforth, Moody’s) for 259
banks in our sample of countries. Our empirical approach consists on exploiting cross-
sectional differences across stock price reactions to sovereign rating agencies, based on
different bank characteristics. Most prominently, we exploit measures of expected
government support to individual banks. We construct our baseline measure of
government support using ratings data from Moody’s. In particular, Moody’s assigns
bank deposit ratings for banks as standalone entities and also assigns bank deposit ratings
that take into account possible external support to the banks (including explicit or implicit
deposit insurance). Our baseline measure of expected government support reflects the
difference between the credit rating that embeds external support and the standalone
rating (Schich and Lindh 2012).
1
To our knowledge, this is one of the first applications
of this measure in empirical studies.
Our main results are as follows:first, we find that sovereign rating changes have a
strong effect on the stock returns of banks that are more likely to receive government
support. This effect is concentrated on sovereign rating downgrades and generally is not
statistically significant for sovereign rating upgrades. These results are robust to using
alternative measures of government support that capture the probability of government
support (e.g., Gropp, Hakenes, and Schnabel 2011) and different event windows.
1
In Section 3, we show that this ratings-based measure of government support is intuitively correlated with
variables that capture the ability and willingness of governments to bail out individual financial institutions.

3
Second, we find that the negative effect of sovereign downgrades on bank stock
returns for banks expected to receive government support is likely not explained by the
effect of the sovereign downgrade on the entire economy. In particular, we find that
banks expected to receive government support have lower stock returns after sovereign
rating downgrades, even when we compare stock market performance against domestic
equity price indexes, which are likely to capture the overall negative effects of
downgrades on domestic economic activity. This result suggests that the negative effects
of a sovereign rating downgrade are disproportionately felt by banks that investors
perceive as likely to receive more government support when in trouble.
Third, we find that the negative stock market performance after sovereign
downgrades of banks expected to receive government support is likely not explained by
holdings of domestic government debt. Unfortunately, bank-level holdings of domestic
government debt are generally not publicly available. However, sovereign debt holdings
for European banks were disclosed as part of stress tests conducted in 2011 with the
objective of restoring market confidence. For the subsample of European banks for
which we observe sovereign debt holdings, we find that banks expected to receive
government support exhibit lower stock returns after a sovereign downgrade, even after
controlling for domestic government debt holdings on bank balance sheets. In addition,
we find that the stock prices of banks with high sovereign debt holdings tend to be
slightly positive around sovereign debt upgrades, but the economic magnitude of this
effect is small relative to the negative effect of sovereign rating downgrades on banks that
market participants expect to receive government support. Our results highlight that
expected government support is a very important channel in explaining the stock market

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This result is stronger for banks in advanced economies where governments are better-positioned to provide that support. Their results suggest that stock market investors perceive sovereigns and domestic banks as markedly interconnected, partly through government guarantees.