An Empirical Study of International Spillover of Sovereign Risk to Bank Credit Risk

• Published date: 01 May 2017
• Date: 01 May 2017
• DOI: http://doi.org/10.1111/fire.12114

The Financial Review 52 (2017) 281–302

An Empirical Study of International

Spillover of Sovereign Risk

to Bank Credit Risk

Winnie P. H. Poon∗

Lingnan University

Jianfu Shen

Hang Seng Management College

John E. Burnett

University of Alabama in Huntsville

Abstract

The severity and complexity of the recent financial crisis has motivated the need for

understanding the relationships between sovereign ratings and bank credit ratings. This is the

first study to examine the impact of the “international” spillover of sovereign risk to bank

credit risk through both a ratings channel and an asset holdings channel. In the first case, the

downgrade of sovereign ratings in GIIPS (Greece, Italy,Ireland, Portugal, and Spain) countries

leads to rating downgrades of banks in the peripheral countries. The second channel indicates

that larger asset holdings of GIIPS debt increases the credit risk of cross-border banks, and

hence, the probabilities of downgrade.

∗Corresponding author: Department of Finance and Insurance, Lingnan University, Castle Peak Road,

Tuen Mun, Hong Kong; Phone: 852-2616-8179; Fax: 852-2616-5326; E-mail: winpoon@ln.edu.hk.

The authors are grateful to the Editor, Richard Warrand an anonymous referee for their detailed comments

and valuable suggestions that greatly improved the paper. The authors would also like to thank Dorla A.

Evans and Kam C. Chan for their useful comments on earlier drafts of the paper. Poon acknowledges a

research grant (DR12B7) from Lingnan University,Hong Kong. The authors thank Cheung Chun-Kit for

his dependable research assistance.

C2017 The Eastern Finance Association 281

282 W. P. H. Poon et al./The Financial Review52 (2017) 281–302

Keywords: bank credit ratings, sovereign credit ratings, spillover effects, credit rating

agencies

JEL Classifications: G01, G21, G24

1. Introduction

The formation of the European Union (EU), and the subsequent eurozone,

intertwined the financial systems of 28 member countries in complex, and sometimes

tenuous, ways.1We examinethe cross-border relationship between sovereign ratings

and bank credit ratings; first to determine whether sovereign rating changes in the so-

called GIIPS countries (Greece, Italy, Ireland, Portugal, and Spain) can trigger bank

rating changes in other countries, and then whether cross-border spillover effects are

related to banks’ asset holdings of GIIPS debt.

What makes this issue so important is the possibility for sovereign tensions

in one country to have direct or indirect negative repercussions on banks in other

countries. Prior to the European financial crisis, greater financial integration meant

banks in the eurozone made large investments in eurozone sovereign bonds. Basel

II created further incentives for banks to own sovereign debt from other eurozone

countries, stipulating that banks need not hold reserves for the highly rated eurozone

sovereign bonds they own. Unfortunately, when the global financial crisis hit, many

EU countries were weakened by burdensome debt loads. They watched as the credit

rating agencies (CRAs) downgraded the ratings of sovereign countries as well as their

debt issues. Naturally, when the quality and safety of a country’s sovereign debt is

downgraded, downgrades of banks within that country can follow. But do sovereign

downgrades spill over to downgrades of banks in other EU countries? If so, it may

hasten and/or deepen a crisis.

Holding a diversified collection of sovereign debt makesa bank less susceptible

to a shock in its own country, but creates additional risk from the direct exposure

to foreign sovereigns. How do CRAs rectify these competing risk factors? Theoret-

ically, Bolton and Jeanne (2011, p. 162, emphasis in the original) show that even

though “diversification generates risk diversification benefits ex ante, it also gener-

ates contagion ex post.” In other words, if high levels of exposure result in systemic

or correlated risks in the face of a crisis, then it may be possible for banks to be

downgraded based on their sovereign debt exposure, reflecting the added risk.

The severity and complexity of the EU crisis resulting from such highly in-

tegrated financial systems motivates the need for understanding the relationships

1The EU is a single market with uniform laws and policies to guide trade among its members. In turn,

the eurozone is an economic and monetary union (with the euro as its currency) composed of 19 (17 as of

2012) of the 28 countries of the EU. In June 2013, Croatia became the most recent country added to the

EU.