An Empirical Study of International Spillover of Sovereign Risk to Bank Credit Risk
Published date | 01 May 2017 |
Date | 01 May 2017 |
Author | Jianfu Shen,John E. Burnett,Winnie P. H. Poon |
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.
C2017 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.
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