Systemic Risk - measuring how credit rating downgrades can contribute to financial crises

Globally renowned Credit Rating Agencies (CRA) such as Moody’s, Fitch Ratings, and S&P, provide credit risk assessment of issues and issuers. Their announcements are closely followed by investors, regulators, and financial media. Indeed, following the Global Financial Crisis (GFC) there was concern that the market had become over-reliant on their guidance, as seen when competing agencies unanimously issued AAA ratings to collaterised debt obligations that subsequently collapsed in value; a collapse measured in trillions of dollars.

Episodes of mis-rating such as these are believed to have been significant contributors to the GFC. Existing literature predominantly focuses on the repercussions of sovereign credit ratings on macro-financial stability, with historical evidence strongly suggesting that changes in country-credit ratings are linked to systemic events and risk. Systemic risk, in this context, refers to the risk of disruption within a financial system stemming from an event at the firm level. The authors of the paper titled "Credit Rating Downgrades and Systemic Risk" make a significant contribution to the existing body of knowledge by examining systemic importance of firm credit rating changes. More specifically, their focus lies on exploring the direct correlation between firm rating downgrades and the associated systemic risk for banks.

Their analysis provides strong evidence that systemic risk is associated with rating downgrades. The size of the rating downgrade matters, and the study finds that rating downgrades from investment to speculative grade have the greatest contribution to systemic risk. Consistent with previous studies which argue that rating downgrades are more informative than upgrades, the research finds no consistent evidence that upgrades can mitigate systemic risk. However, the results do suggest that the positive relationship between rating downgrades and systemic risk can be mitigated by accounting-based stability factors such as stabilising profitability and enhancing bank capital.

Other findings highlight the importance of sovereign downgrades. These include:

• The presence of a sovereign effect. During sovereign rating downgrades of a bank’s home country, bank-level downgrades have a significantly stronger effect.
• Global Systemically Important Banks’ (G-SIBs) idiosyncratic risk from rating downgrade is higher than other banks, although the results on systemic risk vary depending on the measure used (two widely used systemic risk measures were employed for the study).
• Sovereign rating downgrades have a greater effect on systemic risk for bound banks (i.e., banks that have a credit rating equal to or above their country’s rating in the previous year) relative to non-bound banks.

The findings inform several policy recommendations. Firstly, regulatory authorities need to encourage a decrease in reliance on CRAs. While this has been a primary goal for regulators in the aftermath of the GFC, the results of this study suggest that the market is still largely dependent on credit ratings, as demonstrated by increased systemic risk following rating downgrades.

Secondly, the research supports calls for greater transparency in the CRA market. Since inflated ratings can increase the impact of large and unexpected rating downgrades, greater transparency should limit adverse systemic consequences.

Thirdly, contrary to recent studies claiming the CRA market has shifted to a more conservative rating evaluation and that rating downgrades have become less informative, the results of this study suggest that the market continues to react strongly to rating downgrades, increasing the systemic vulnerabilities of the financial system.

The study shows that regulatory policies on enhancing bank capital and stabilising profitability remain powerful tools that can absorb part of the systemic risk associated with rating downgrades.

Finally, the findings highlight the importance of sovereign rating downgrades for systemic risk, especially for bound banks. This raises a cautionary flag for the role of the sovereign ceiling rule that leads to increased systemic risk due to the asymmetric changes in credit ratings.

The published version of Credit rating downgrades and systemic risk is available for download at City Research Online. It is published in Journal of International Financial Markets, Institutions and Money.