The impact of sovereign rating changes on the activity of European banks

We verify the effects of sovereign rating revisions on the activity of European banks, in terms of their regulatory capital ratio, profitability, liquidity, and lending supply. First, we find that a sovereign downgrade has a significant impact, primarily on capital ratios and lending supply. In contrast, upgrades do not have a significant impact, indicating an asymmetric effect of sovereign rating changes. Second, we find that three transmission channels (assets channel, funding channel, and rating channel) explain a relevant part of the impact of a sovereign downgrade. Finally, we find strong evidence that the rating-based regulation affects all measures of the activity of domestic banks, causing negative externalities for financial institutions. Our results hold also controlling for sovereign risk, estimating a GMM system, and employing an instrumental variable approach.