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The impact of sovereign rating changes on the activity of European banks

Danilo Drago and Raffaele Gallo

Journal of Banking & Finance, 2017, vol. 85, issue C, 99-112

Abstract: 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 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 rating-based regulation affects all measures of the activity of domestic banks, causing negative externalities for financial institutions. Our results hold also controlling for sovereign risk, estimating a GMM system, and employing an instrumental variable approach.

Keywords: Sovereign credit rating; Bank activity; Bank capital; Bank loan supply; Rating-based regulation (search for similar items in EconPapers)
JEL-codes: G21 G24 G28 H63 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:jbfina:v:85:y:2017:i:c:p:99-112