The impact of reasons for credit rating announcements in equity and CDS markets

Over the last four decades the literature on bond rating changes and its effects on security prices increased significantly with almost all studies not controlling for the respective reason for those. We therefore investigate the impact of rating events on the stock and the credit default swap (CDS) market incorporating rating reviews and rating changes together with the reason mentioned by the rating agency. Our results for the general effects are in line with prior findings but conditioning on the respective reason shows that the markets’ anticipation of rating actions is largely driven by events due to changes in firms’ operating performance. Furthermore, we provide empirical evidence for the hypothesis in prior literature that a surprise downgrade does not necessarily have to be bad news for stockholders when wealth is transferred from bondholders, but negative rating actions are always bad news for bondholders. The results additionally reveal increasing rating announcement effects by declining credit quality of firms for both rating reviews and changes. JEL Classification: D82, G14, G20. Keywords: Credit Default Swaps, Credit Ratings, Credit Rating Reasons, Event Study

Covenant Violations, Loan Contracting, and Default Risk of Bank Borrowers

Are borrowers rewarded for repaying their loans? This paper investigates the consequences of covenant violations on subsequent loans to the same borrower using a hand-collected sample of US syndicated loans during the 1996 to 2010 period. We find that covenant violations have substantial negative effects for borrowers in subsequent loans. Our results show that the loan spread increases by 22 basis points in the loan following the violation. We also find that the new contract includes more financial covenants which are also more restrictive. Switching banks after a violation does not reduce these effects and even leads to a further increase in loan spreads. We also provide empirical evidence that borrowers who have violated covenants in the previous contract are significantly more likely to violate covenants again in the next loan. Moreover, they violate earlier compared to borrowers who have not violated covenants before. Most importantly, these borrowers also exhibit a substantially higher likelihood to default, particularly in the first 100 days after a violation. Our results suggest that there is an important role for covenants in monitoring borrowers and that covenant violations provide an early warning signal for a severe deterioration of borrower credit quality

Does the lack of financial stability impair the transmission of monetary policy?

We investigate the transmission of central bank liquidity to bank deposits and loan spreads in Europe over the January 2006 to June 2010 period. We find evidence consistent with an impaired transmission channel due to bank risk. Central bank liquidity does not translate into lower loan spreads for high-risk banks, even as it lowers deposit rates for both high-risk and low-risk banks. This adversely affects the balance sheets of high-risk bank borrowers, leading to lower payouts, lower capital expenditures, and lower employment. Overall, our results suggest that banks’ capital constraints at the time of an easing of monetary policy pose a challenge to the effectiveness of the bank lending channel and the effectiveness of the central bank as a lender of last resort

The Roles of Corporate Governance in Bank Failures during the Recent Financial Crisis

Abstract: This paper analyzes the roles of corporate governance in bank defaults during the recent financial crisis of 2007-2010. Using a data sample of 249 default and 4,021 no default US commercial banks, we investigate the impact of bank ownership and management structures on the probability of default. The results show that defaults are strongly influenced by a bank’s ownership structure: high shareholdings of outside directors and chief officers (managers with a “chief officer” position, such as the CEO, CFO, etc.) imply a substantially lower probability of failure. In contrast, high shareholdings of lower-level management, such as vice presidents, increase default risk significantly. These findings suggest that high stakes in the bank induce outside directors and upper-level management to control and reduce risk, while greater stakes for lower-level management seem to induce it to take high risks which may eventually result in bank default. Some accounting variables, such as capital, earnings, and non-performing loans, also help predict bank default. However, other potential stability indicators, such as the management structure of the bank, indicators of market competition, subprime mortgage risks, state economic conditions, and regulatory influences, do not appear to be decisive factors in predicting bank default.