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Tsegradu2016inkinen.Pdf (1.586Mb) INFORMATION CONTENT OF BANK CREDIT RATING CHANGES Evidence from Europe Master´s Thesis in Accounting and Finance Author: Lauri Inkinen Supervisors: Prof. Hannu Schadewitz Ph.D. Vesa Partanen 1.8.2016 Turku Turun kauppakorkeakoulu • Turku School of Economics The originality of this thesis has been checked in accordance with the University of Turku quality assurance system using the Turnitin OriginalityCheck service. Table of contents 1 INTRODUCTION ................................................................................................... 7 1.1 Growing importance of credit ratings ............................................................ 7 1.2 Study objective ............................................................................................... 9 1.3 Event study methodology ............................................................................. 10 1.4 Thesis structure ............................................................................................ 12 2 THEORY AND LITERATURE ............................................................................ 14 2.1 Credit rating industry ................................................................................... 14 2.1.1 Development and current state of the industry ................................ 14 2.1.2 Functions of credit ratings ............................................................... 17 2.1.3 Rating types and scales .................................................................... 19 2.1.4 Rating process .................................................................................. 21 2.1.5 Criticism of rating agencies ............................................................. 23 2.2 Features of the banking industry and the role of credit ratings .................... 25 2.2.1 Overview of the industry ................................................................. 25 2.2.2 Rating-based regulation in banking ................................................. 26 2.2.3 Characteristics of the European banking sector ............................... 28 2.3 Review of literature of credit rating announcements ................................... 29 2.3.1 Introduction to the research field ..................................................... 29 2.3.2 Debt market reaction ........................................................................ 31 2.3.3 Stock market reaction ...................................................................... 32 2.3.4 Bank-related research....................................................................... 34 3 HYPOTHESES ...................................................................................................... 40 3.1 Main hypotheses ........................................................................................... 40 3.2 Additional tests ............................................................................................. 42 4 DATA AND METHODS ...................................................................................... 45 4.1 Methodological choices and dilemmas ........................................................ 45 4.1.1 Event study....................................................................................... 45 4.1.2 Cross-sectional regression analysis.................................................. 49 4.1.3 Problems and limitations.................................................................. 50 4.2 Data .............................................................................................................. 53 5 EMPIRICAL RESULTS ....................................................................................... 59 5.1 Credit rating changes .................................................................................... 59 5.1.1 Full sample and overview ................................................................ 59 5.1.2 Downgrades ..................................................................................... 60 5.1.3 Upgrades .......................................................................................... 62 5.1.4 Regression results ............................................................................ 64 5.2 Credit rating watches .................................................................................... 65 5.2.1 Overview .......................................................................................... 65 5.2.2 Downgrades ..................................................................................... 66 5.2.3 Upgrades .......................................................................................... 68 6 SUMMARY AND CONCLUSIONS .................................................................... 71 REFERENCES................................................................................................................ 75 Appendices Appendix 1 List of banks used in the study .......................................................... 81 List of figures Figure 1 Rating process .................................................................................... 23 Figure 2 STOXX Europe 600 Banks Price Index (2000–2015) ....................... 28 Figure 3 Event study timeline ........................................................................... 45 Figure 4 Distribution of ratings across time ..................................................... 55 Figure 5 Distribution of rating watches across time ......................................... 57 Figure 6 Cumulative average abnormal returns of rating changes ................... 60 Figure 7 Average abnormal returns of rating changes (downgrades) ............... 61 Figure 8 Average abnormal returns of rating changes (upgrades) .................... 63 Figure 9 Cumulative average abnormal returns of rating watches ................... 66 Figure 10 Average abnormal returns of rating watches (downgrades) ............... 67 Figure 11 Average abnormal returns of rating watches (upgrades) .................... 69 List of tables Table 1 Nationally recognized statistical rating organizations in 2015........... 16 Table 2 Long-term issuer-specific rating classes ............................................ 20 Table 3 Summary of studies concerning bank stock prices............................. 39 Table 4 Distribution of ratings across nations ................................................. 54 Table 5 Distribution of ratings across time ..................................................... 54 Table 6 Distribution of ratings between agencies ........................................... 55 Table 7 Descriptive information about the sample .......................................... 57 Table 8 Summary of abnormal returns of rating changes (full sample) .......... 59 Table 9 Summary of abnormal returns of rating changes (downgrades) ........ 61 Table 10 Summary of abnormal returns of rating changes (upgrades) ............. 63 Table 11 Cross-sectional regression .................................................................. 64 Table 12 Summary of abnormal returns of rating watches (downgrades) ........ 67 Table 13 Summary of abnormal returns of rating watches (upgrades) ............. 69 7 1 INTRODUCTION 1.1 Growing importance of credit ratings Partnoy (2006, 61) compresses the paradox of the existence of credit ratings as follows: “Rating changes are important, yet they possess little informational value. Credit rat- ings do not help parties manage risk, yet parties increasingly rely on ratings. Credit rating agencies are not widely respected among sophisticated market participants, yet their franchise is increasingly valuable. The agencies argue that they are merely fi- nancial journalists publishing opinions, yet ratings are far more valuable than the opinions of even the most prominent and respected financial publishers.” Since the beginning of the rating industry, people have raised questions about the ex- istence of credit ratings. This is certainly not surprising. In just one century the industry has managed to grow huge in size and has created a strong regulatory barrier for new- comers to enter into the market. This has kept the number of rating agencies rather small through years. The major participants dominating the industry with a market share of some 95 percent, Standard & Poor’s (S&P), Moody’s Investors Service and Fitch Ratings, have been around since the inception of the industry. (White 2010) A matter of concern is the fact that the whole financial system is crucially dependent on credit ratings. Credit ratings, among other things, ameliorate information asymmetry between issuers and investors, as well as are heavily used in financial regulation (Rhee 2015, 162–163). Thus, although credit ratings are argued to be merely publishing opin- ions of financial journalists, they are not absolutely consumed as those (Partnoy 2006). As ratings are produced by humans, mistakes and conflicts of interest can never fully be avoided. This, and the oligopolistic industry created with the help of regulators, naturally raises problems and criticism. The debate has been especially vigorous over the 21st century. There are several rea- sons explaining this. First, everyone remembers the worn-out examples of Enron and WorldCom which received fine ratings just before their collapses in the beginning of the century. Second, rating agencies are blamed for playing a key role in the 2007–2008 fi- nancial crisis due to their inadequate performance, mostly related to structured debt prod- ucts (see e.g. Pagano & Volpino 2010).
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