The 19 reference contexts in paper Rabah Arezki, Bertrand Candelon, Amadou Sy (2011) “Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis” / RePEc:ces:ceswps:_3411

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    A sovereign rating downgrade in a given country is thus likely to affect the profitability of banks in other countries where banks are holding this debt. This is the case of Europe where banks hold at times substantial amount of sovereign debt in both their trading and banking books (see
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    Blundell-Wignall and Slovik, 2010).
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    Another example of channels through which sovereign rating news may spill over across countries and markets is when banks across countries hold claims on banks in other countries and are thus exposed to one another.
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    Another example of channels through which sovereign rating news may spill over across countries and markets is when banks across countries hold claims on banks in other countries and are thus exposed to one another. This cross-holding feature is at the core of the European financial market convergence process in Europe. 2
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    Sy (2010)
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    provides a comprehensive discussion of the channels through which sovereign credit rating announcements may spillover to other markets including as a result of rating-based triggers such as those in banking regulation, ECB collateral rules, CDS contracts or investment mandates.
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    rating announcements may spillover to other markets including as a result of rating-based triggers such as those in banking regulation, ECB collateral rules, CDS contracts or investment mandates. In spite of these channels, the literature on the spillover effects of rating news is sparse. Considering sovereign bond spreads data from emerging markets spanning the period 1991 to 2000,
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    Gande and Parsley (2005)
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    find that a country’s rating downgrade has a significant negative effect on the sovereign bond spreads of other countries. In integrated financial markets, however, one should expect rating downgrade to have effects beyond bond markets.
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    sovereign bond spreads data from emerging markets spanning the period 1991 to 2000, Gande and Parsley (2005) find that a country’s rating downgrade has a significant negative effect on the sovereign bond spreads of other countries. In integrated financial markets, however, one should expect rating downgrade to have effects beyond bond markets. Indeed, a nascent literature including
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    Ehrmann, Fratzscher and Rigobon (2010)
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    analyze the transmission of shocks both across markets and countries. They find evidence of substantial international spillovers, both within and across asset classes. Kaminsky and Schmukler (2002) provide some evidence that changes in sovereign debt ratings and outlooks affect financial markets in emerging economies.
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    Kaminsky and Schmukler (2002) provide some evidence that changes in sovereign debt ratings and outlooks affect financial markets in emerging economies. More specifically, they find that sovereign rating affect not only the instrument being rated (bonds) but also stocks. In line with
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    Gande and Parsley (2004) and
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    Kaminsky and Schmukler (2002), the present paper examines the impact of rating news on credit markets (albeit focusing on CDS markets) but considers more systematically the potential spillover effects that structurally exist within different asset market classes using stock market indices as well as banking and 2 It has been stimulated by the
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    the impact of rating news on credit markets (albeit focusing on CDS markets) but considers more systematically the potential spillover effects that structurally exist within different asset market classes using stock market indices as well as banking and 2 It has been stimulated by the first and second banking directive in 1977 and 1985.
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    BIS (2010)
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    provides figures on cross-border holding across countries. 4 insurance sub-indices. Also, the present paper is, to the extent of our knowledge, the first to focus on the spillover effects of sovereign rating news on mature markets namely Eurozone countries.
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    Indeed, previous studies have focused on emerging markets where exchange rate fluctuations render difficult the identification of the effect of credit rating news. To do so, we use a VAR framework inspired from
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    Favero and Giavazzi (2002)
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    using dummies to capture the effect of sovereign rating news on various financial markets across countries. 3 Our approach combines event study techniques with the interdependence literature (see inter alia Favero and Giavazzi, 2002) and allows identifying which markets and countries are affected by any given sovereign rating downgrade.
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    To do so, we use a VAR framework inspired from Favero and Giavazzi (2002) using dummies to capture the effect of sovereign rating news on various financial markets across countries. 3 Our approach combines event study techniques with the interdependence literature (see inter alia
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    Favero and Giavazzi, 2002) and
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    allows identifying which markets and countries are affected by any given sovereign rating downgrade. We are also able to capture the dynamic spillover effect of rating news on different asset classes across countries by controlling for the lagged effects of the fluctuations in those assets.
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    Section 5 presents robustness checks. Section 6 concludes. 3 This is shown to be equivalent to other empirical approach to identify contagion as documented in
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    Dungey et al. (2004).
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    5 II. The European Debt Crisis through the Lens of Credit Rating Agencies We focus on the three major credit rating agencies, i.e. Fitch, Moody’s and Standard and Poor’s (S&P) making announcements of various types, namely rating changes (upgrades and downgrades), revision of outlook (positive and negative) and review for future rating changes.
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    This could also suggest that credit rating agencies anticipate that those rating downgrades are temporary and that in the future European countries would recover their pre-crisis grade. 4
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    Mora (2006)
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    among others provides evidence of delayed sovereign rating announcements of credit rating agencies in the context of the Asian crisis. White (2010) provides an excellent overview of the literature on credit rating agencies including on the evidence of their sluggishness in making corporate rating announcements in the US. 9 Figure 2: Positive and Negative Announcements over Time 6 4 2 0 Sept
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    This could also suggest that credit rating agencies anticipate that those rating downgrades are temporary and that in the future European countries would recover their pre-crisis grade. 4 Mora (2006) among others provides evidence of delayed sovereign rating announcements of credit rating agencies in the context of the Asian crisis.
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    White (2010)
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    provides an excellent overview of the literature on credit rating agencies including on the evidence of their sluggishness in making corporate rating announcements in the US. 9 Figure 2: Positive and Negative Announcements over Time 6 4 2 0 September-06July-07May-08March-09January-10 -2 -4 -6 -8 C.
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    Estimation Strategy and Data In order to investigate the effect of rating announcements, hereafter labeled as “rating news”, on a specific market i, most studies have so far used event study techniques. 5 This approach consists in explaining the return on market i (r i ) by a sequence of impulse dummies Dt 5
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    Gande and Parsley (2004)
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    constitutes a reference for such an approach applied to sovereign debt market. 11 characterizing the rating news released at time t. 6 Formally, the relationship with the market return and the news can be expressed as follows: r i t = a i +b i Dt + e i t, (1) e i t being i.i.d and white noise residuals.
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    First, it is assumed that market i is efficient as the return does not depend on past variables. In theory, the efficient market hypothesis implies that there should not be predictable changes in asset prices (see
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    Fama, 1970).
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    The intuition behind such hypothesis is that if everyone believed that the price of a stock would fall tomorrow, they would bid down the price today and the price would thus adjust instantaneously. However, there is a large body of empirical literature providing evidence of departures from market efficiency.
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    However, there is a large body of empirical literature providing evidence of departures from market efficiency. Second, such a specification relies on the assumption that financial markets are not interrelated. However, the literature on financial globalization has shown otherwise (see
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    Granger et al (2000)).
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    There are evidence of spillovers between countries and between markets within the same country. Those spillover effects can be of a long-run nature often referred to as “interdependence” and of a short-run nature often referred to as “contagion”.
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    Using model (1’) to evaluate the impact of rating news on financial markets would lead to a bias not only in the scope but also in the magnitude of the estimation. Hence, our event study takes into account the potential linkages between markets. As in
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    Favero and Giavazzi (2002),
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    we consider a Vector Autoregression (VAR) framework. Variables are included in levels to allow for the possibility of long-run/cointegration 6 The impulse dummy is 1 at time t and zero otherwise. 12 relationships. 7 The model we use in the following econometric analysis takes the following form: Z i t = Φ (L) Z i t + v i t (2) where Z i t
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    Using such a specification will also allow us to obtain unbiased estimates of the effect of the rating news on market prices, disentangling the effects of the structural linkages between market (characterized by Φ(L)) and the impact of credit rating news via the matrix b ij ). 7
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    Engle and Granger (1987)
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    showed that considering a VAR in difference while there exists one or more cointegration relationships would result in biases in the estimators. 13 IV. Results The model is first estimated without dummies in order to exhibit the potential linkages between financial markets.8 We then introduce all individual dummies at once in the VAR model using the rating announcements described in Secti
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    It suggests that there is heterogeneity of coefficients associated with the dummies across countries. Such a result highlights the transmission heterogeneity of rating news across European countries, preventing us to use panel data techniques assuming homogeneity across countries as in
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    Gande and Parsley (2005) and Kaminsky and Schmuckler (2002).
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    We therefore conduct our estimation for each individual country separately. B. Interdependence between Markets The model is first estimated without considering any exogenous variables. It corresponds hence to model (2): Z i t = Φ(L) Z i t + v i t.
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    First, as soon as other countries are downgraded, policy makers should act preventively by communicating effectively to dissipate concerns regarding what 17
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    BIS (2010)
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    documents US banks’ exposure to Euro zone countries. 25 market participants perceive as weaknesses. Second, since spillover effects go beyond sovereign debt markets, policy makers should be prepared to address possible instability in the banking, insurance, and non-financial sector by preparing a contingency plan.
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    Third, as financial instability may stem from the existence of ratings-based regulations, policy makers should review the appropriateness of using credit ratings in financial markets regulation. 18 18 The Financial Stability Board
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    (FSB, 2010)
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    presents a number of principles for reducing reliance on credit ratings. 26
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