Stock price effects of bank rating announcements: An application to European Union countries

• Published date: 01 January 2019
• DOI: http://doi.org/10.1002/ijfe.1645
• Date: 01 January 2019

RESEARCH ARTICLE

Stock price effects of bank rating announcements: An

application to European Union countries

Júlio Lobão

1

| Luís Pacheco

2,3

| Susana Campos

1

1

School of Economics and Management,

University of Porto, Porto, Portugal

2

Department of Economics and

Management, Portucalense University,

Porto, Portugal

3

REMIT ‐Research on Economics,

Management and Information

Technologies, Portucalense University,

Porto, Portugal

Correspondence

Júlio Lobão, School of Economics and

Management, University of Porto, Dr.

Roberto Frias, Porto 4200‐464, Portugal.

Email: jlobao@fep.up.pt

JEL Classification: G1; G14

Abstract

This paper uses daily stock prices data surrounding credit rating announce-

ment dates to examine abnormal returns of stocks of the European Union

banks experiencing debt rating announcements, during the period 2004–2015.

The results of the event studies suggest that rating agencies, by issuing

downgrades and upgrades, provide relevant information to capital markets.

The results also indicate that rating agencies contribute to enhance the

transparency and efficiency in capital markets by standardizing information

for all investors. The large positive preupgrade returns we observe are consis-

tent with the view that upgrades are of most interest to market investors. There

is no significant evidence of abnormal returns on announcements of rating

watches.

KEYWORDS

banks, credit ratings, event study, market efficiency, stock market

1|INTRODUCTION

This paper uses daily stock prices data surrounding rating

announcement dates to examine abnormal returns of

stocks of the European Union (EU) banks experiencing

debt rating announcements in the period 2004–2015. It

is a contribution for the debate about the information

content of bank debt ratings in the stock market

perspective.

There are three main motivations for conducting this

study. First, there is a widespread perception that the

financial community closely follows the opinions of

rating agencies. The study of investors'reaction to the

recommendations of the rating agencies is a test of the

role that these agencies play in the setting of these market

participants'expectations. Second, when these ratings are

incorrectly assigned, all the economy is affected. Follow-

ing this reasoning, rating agencies were criticized after

the banking collapse in 2008 for misrating financial

products, contributing to the severity of the collapse

(Financial Crisis Inquiry Commission, 2011). This leads

to the third motivation, because although a vast literature

has already been dedicated to the role of the rating

agencies and their impact on financial markets, the

debate on their responsibility during the recent financial

crisis suggests that they are still a controversial topic. In

this sense, testing the reaction to the opinions issued by

the rating agencies is of paramount importance insofar

as it also constitutes an examination of the social utility

of that industry.

Previous research on the information content of rat-

ing announcements has produced incomplete results.

Research for U.S. firms generally suggests that bad news

negatively impacts prices in the short term, whereas

there is no significant market reaction to good news

(e.g., Goh & Ederington, 1993; Holthausen & Leftwich,

1986). There is limited evidence that in a non‐U.S. mar-

ket, there is more significant positive reaction to good

news (e.g., Gropp & Richards, 2001). In part, this is

because outside the United States, there are few similar

studies about rating change announcements. This is not

surprising, because the penetration of ratings in Europe

Received: 18 April 2017 Revised: 9 January 2018 Accepted: 26 June 2018

DOI: 10.1002/ijfe.1645

4© 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2019;24:4–19.wileyonlinelibrary.com/journal/ijfe

is historically lower than in the United States (Dale &

Thomas, 2001). The role of rating watches has also

received little study, as compared with rating changes,

either in the United States or in Europe.

Besides, as argued by Schweitzer, Szewczyk, and

Varma (1992), there are reasons to think that rating

changes might have a lower impact on banks, as highly

regulated entities, as compared with nonfinancial compa-

nies. They say that the regulation of an industry may

increase the amount of information available to the

market. Furthermore, there are also few similar studies

using a sample period during the recent financial crisis

and analysing a sample of banks.

This paper is primarily motivated by the question: Are

bank debt rating changes associated with valuable

information content events to the stock market in the

EU context? In light of previous research, it is argued that

the existence of abnormal returns on the announcement

date of a rating is evidence that agencies provide some

information not already incorporated into prices. The

following questions are also investigated: Are these

announcements anticipated? Are there any

postannouncement effects associated with them? Do

rating watch announcements provide new information

to the stock market?

This paper is structured as follows. Section 2 reviews

the relevant literature. Section 3 presents the data and

the methodology. Section 4 presents the empirical results

concerning the effect of rating changes and rating watch

changes on stock returns. Section 5 concludes the paper.

2|LITERATURE REVIEW

2.1 |Rating change announcements

Concerning the empirical research about the impact of

credit rating change announcements on security prices,

there are some complementary theories related to the

information content value of ratings and to the wealth

redistribution between bondholders and stockholders.

Moreover, there are two alternative views of the infor-

mation content value of ratings produced by rating agen-

cies. One view is defended by Weinstein (1977), among

others, who find no evidence of a price response to rating

changes. They argue that rating agencies only have access

to publicly available information, so capital markets are

efficient in semistrong form and debt ratings should not

affect market prices. Nevertheless, most literature is

inconsistent with this evidence. The other view, defended

and empirically validated by Holthausen and Leftwich

(1986); Hand, Holthausen, and Leftwich (1992);

Schweitzer et al. (1992); and Gropp and Richards (2001),

among others, is that rating agencies have considerable

nonpublic information about a company, and thus a

credit rating change may provide new information to

the market and should affect security prices, with the

stock price of downgraded (upgraded) firms declining

(increasing). Proponents of this view argue that the main

role of credit ratings is to enhance transparency and effi-

ciency in debt capital markets by standardizing informa-

tion for all investors and reducing the information

asymmetry between borrowers and lenders, enhancing

investor confidence, and allowing borrowers to have

broader access to funds thus helping to lower the aggre-

gate costs of borrowing and lending (McDaniel, 2002).

The theory about the wealth redistribution between

bondholders and stockholders (Goh & Ederington, 1993)

focuses on the conflict of interests between them by

taking into account the reason for the rating change. On

one hand, if stockholders increase the expected return

on a firm by taking on riskier investments (strategy that

increases the default risk of outstanding bonds) and

because of this the firm is downgraded, this downgrade

should be good (bad) news for stockholders (bond-

holders) leading to a stock (bond) price increase

(decrease). On the other hand, if a downgrade reflects

new negative information about firm's earnings or sales,

this downgrade should be bad news for bondholders

and stockholders leading to stock and bond price

decreases.

Previous research, mostly using samples of U.S. firms,

tends to conclude to a lack of significant impact on stock

returns in case of upgrades, suggesting no information

content (Goh & Ederington, 1993; Holthausen &

Leftwich, 1986). In case of downgrades, the empirical

literature, such as Holthausen and Leftwich (1986) and

Jorion and Zhang (2007), often reports economically large

and significant effects on daily stock returns. With a sam-

ple of U.S. companies, Dichev and Piotroski (2001) find

negative abnormal returns in the first year following

downgrades and this underperformance is especially pro-

nounced for small, low‐credit‐quality firms, where there

is a greater potential for informational inefficiencies.

Regarding the literature of the impact of bank ratings,

as argued by Schweitzer et al. (1992), there are reasons to

think that rating changes might have a lower impact on

banks, as highly regulated entities, as compared with

nonfinancial companies. They say that the regulation of

an industry may increase the amount of information

available to the market. Using a sample of U.S. bank

holding companies, their findings suggest that rating

agencies provide valuable information to the market

through downgrades and that market reactions to the

ratings of banks are not reduced relative to those for

unregulated industrial firms. However, Wansley and

Dhillon (1989) and Polonchek, Slovin, and Sushka

LOBÃO ET AL.5