The Joint Dynamics of Sovereign Ratings and Government Bond Yields
Makram El-Shagi, Gregor von Schweinitz
Abstract
In the present paper, we build a bivariate semiparametric dynamic panel model to repro-duce the joint dynamics of sovereign ratings and government bond yields. While the individual equations resemble Pesaran-type cointegration models, we allow for different long-run relationships in both equations, nonlinearities in the level effect of ratings, and asymmetric effects in changes of ratings and yields. We find that the interest rate equation and the rating equation imply significantly different long-run relationships. While the high persistence in both interest rates and ratings might lead to the misconception that they follow a unit root process, the joint analysis reveals that they converge slowly to a joint equilibrium. While this indicates that there is no vicious cycle driving countries into default, the persistence of ratings is high enough that a rating shock can have substantial costs. Generally, the interest rate adjusts rather quickly to the risk premium that is in line with the rating. For most ratings, this risk premium is only marginal. However, it becomes substantial when ratings are downgraded to highly speculative (a rating of B) or lower. Rating shocks that drive the rating below this threshold can increase the interest rate sharply, and for a long time. Yet, simulation studies based on our estimations show that it is highly improbable that rating agencies can be made responsible for the most dramatic spikes in interest rates.
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Risk and Return - Is there an Unholy Cycle of Ratings and Yields?
Makram El-Shagi, Gregor von Schweinitz
Economics Letters,
2015
Abstract
After every major financial crisis, the question about the responsibility of the rating agencies resurfaces. Regarding government bonds, the most frequently voiced concern targeted “unreasonably” bad ratings that might trigger capital flights and increasing risk premia which sanction further rating downgrades. In this paper we develop a multivariate, nonparametric version of the Pesaran type cointegration model that allows for nonlinearities, to show that a unique equilibrium between ratings and sovereign yields exists. Therefore, we have to reject the concern that there is an unholy cycle leading to certain default in the long run.
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The Political Determinants of Sovereign Bond Yield Spreads
Stefan Eichler
Journal of International Money and Finance,
No. 46,
2014
Abstract
This paper analyzes the political determinants of sovereign bond yield spreads using data for 27 emerging markets in the period 1996 to 2009. I find strong evidence that countries with parliamentary systems (as opposed to presidential regimes) and a low quality of governance face higher sovereign yield spreads, while the degree of democracy and elections play no significant role. A higher degree of political stability and the power to implement austerity measures significantly reduce sovereign yield spreads particularly in autocratic regimes, while no significant effect is detected for democratic countries. Overall, political determinants have a more pronounced impact on sovereign bond yield spreads in autocratic and closed regimes than in democratic and open countries.
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The Impact of Public Guarantees on Bank Risk-taking: Evidence from a Natural Experiment
Reint E. Gropp, C. Gruendl, Andre Guettler
Review of Finance,
No. 2,
2014
Abstract
In 2001, government guarantees for savings banks in Germany were removed following a lawsuit. We use this natural experiment to examine the effect of government guarantees on bank risk-taking. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. Using a difference-in-differences approach we show that none of these effects are present in a control group of German banks to whom the guarantee was not applicable. Furthermore, savings banks adjusted their liabilities away from risk-sensitive debt instruments after the removal of the guarantee, while we do not observe this for the control group. We also document that yield spreads of savings banks’ bonds increased significantly right after the announcement of the decision to remove guarantees, while the yield spread of a sample of bonds issued by the control group remained unchanged. The evidence implies that public guarantees may be associated with substantial moral hazard effects.
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Sovereign Credit Risk, Banks' Government Support, and Bank Stock Returns around the World: Discussion of Correa, Lee, Sapriza, and Suarez
Reint E. Gropp
Journal of Money, Credit and Banking,
s1
2014
Abstract
In the years leading up to the 2008–09 financial crisis, many banks around the world greatly expanded their balance sheets to take advantage of cheap and abundantly available funding. Access to international funding markets, in particular, made it possible for banks to reach a size that in some cases was a large multiple of their home countries’ gross domestic product (GDP). In Iceland, for example, assets of the banking system reached up to 900% of GDP in 2007. Similarly, by the end of 2008, assets in UK and Swiss banks exceeded 500% of their countries’ GDPs, respectively. Banks may also have grown rapidly because they may have wanted to reach too-big-to-fail status in their country, implying even lower funding cost (Penas and Unal 2004).
The depth and severity of the 2008–09 financial crisis and the subsequent debt crisis in Europe, however, have cast doubts on the ability of governments to bail out banks when they experience severe difficulties, in particular, in financially fragile environments and faced with large budget imbalances. This has resulted in as what some observers have dubbed a “doom loop”: the combination of weak public finances and weak banks results in a vicious cycle, in which the funding cost of banks increases, as the ability of governments to bail out banks is called into question, in turn increasing the funding cost of these banks and making the likelihood that the government will actually have to step in even higher, which in turn increases funding cost to the government and so forth.
Against this background, the paper by Correa et al. (2014) explores the link between sovereign rating changes and bank stock returns. They show large negative reactions of stock returns in response to sovereign ratings downgrades for banks that are expected to receive government support in case of failure. They find the strongest effects in developed economies, where the credibility of government bail outs is higher ex ante, while the effects are smaller in developing and emerging economies. In my view, the paper makes a number of important contributions to the extant literature.
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Modelling Macroeconomic Risk: The Genesis of the European Debt Crisis
Gregor von Schweinitz
Hochschulschrift, Juristische und Wirtschaftswissenschaftliche Fakultät der Martin-Luther-Universität Halle-Wittenberg,
2013
Abstract
Diverging European sovereign bond yields after 2008 are the most visible sign of the European debt crisis. This dissertation examines in a first step, to which extent the development of yields is driven by credit and liquidity risk, and how it is influenced by general uncertainty on financial markets. It can be shown that yields are driven to a significant degree by a flight towards bonds of high liquidity in times of high market uncertainty. In a second step, high yields are interpreted as a sign of an existing crisis in the respective country. Using the signals approach, the early-warning capabilities of four different proposals for the design of the scoreboard as part of the “Macroeconomic Imbalances Procedure” (introduced in December 2011 by the European Commission) are tested, advocating a scoreboard including a variety of many different indicators. In a third step, the methodology of the signals approach is extended to include also results on significance.
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The Ex Ante versus Ex Post Effect of Public Guarantees
H. Evren Damar, Reint E. Gropp, Adi Mordel
D. Evanoff, C. Holthausen, G. Kaufman and M. Kremer (eds), The Role of Central Banks in Financial Stability: How has it Changed? World Scientific Studies in International Economics 30,
2013
Abstract
In October 2006, Dominion Bond Rating Service (DBRS) introduced new ratings for banks that account for the potential of government support. The rating changes are not a reflection of any changes in the respective banks’ credit fundamentals. We use this natural experiment to evaluate the consequences of bail out expectations for bank behavior using a difference in differences approach. The results suggest a striking difference between the effects of bail out probabilities during calm times (“ex ante”) versus during crisis times (“ex post”). During calm times, higher bail-out probabilities result in higher risk taking, consistent with the moral hazard view and much of the empirical literature. However, in crisis times, we find that banks with higher bail out probabilities tend to increase their risk taking less compared to banks that were ex ante unlikely to be bailed-out. Charter values are one part of the explanation: Supported banks may have a funding advantage relative to non-supported banks during the crisis. However, we cannot rule out that other factors also may be playing a role, including tighter supervision of supported banks in crisis times.
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Sovereign Default Risk and Decentralization: Evidence for Emerging Markets
Stefan Eichler, M. Hofmann
European Journal of Political Economy,
No. 32,
2013
Abstract
We study the impact of decentralization on sovereign default risk. Theory predicts that decentralization deteriorates fiscal discipline since subnational governments undertax/overspend, anticipating that, in the case of overindebtedness, the federal government will bail them out. We analyze whether investors account for this common pool problem by attaching higher sovereign yield spreads to more decentralized countries. Using panel data on up to 30 emerging markets in the period 1993–2008 we confirm this hypothesis. Higher levels of fiscal and political decentralization increase sovereign default risk. Moreover, higher levels of intergovernmental transfers and a larger number of veto players aggravate the common pool problem.
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