VoxEU Column Financial Markets Global crisis

Real effects of credit rating downgrades

In the wake of the Crisis, policymakers have introduced liquidity regulation to promote the resilience of banks and lower the social cost of crisis management. This column shows that a funding liquidity shock, manifested as lower access to wholesale sources of funding following a credit rating downgrade, translates into a significant decline in both domestic and foreign lending. Liquidity self-insurance by banks mitigates the impact of a credit rating downgrade on lending.

Moral hazard created by central banks’ support to banks during crises (Acharya and Tuckman 2013) and the stigma attached to central banks’ emergency facilities (Armentier et al. 2013) is leading policymakers to broaden the regulatory framework by introducing new liquidity requirements. Furthermore, as bank funding increasingly extends beyond traditional deposits toward a greater reliance on credit-rating-sensitive wholesale forms of funding, liquidity self-insurance gains prominence as a necessary complement to the lender of last resort function of central banks and to deposit insurance.

There is abundant anecdotal evidence and reporting in the press that banks that were downgraded during the Global Crisis faced higher funding costs and collateral requirements, and at times even lost total access to some forms of funding due to rating trigger clauses (Financial Times, 21 May 2012). In Karam et al. (2014), we show that reduced access to funding markets in turn may have material real consequences stemming from the ability of banks to extend credit to households and corporates, and we also assess the importance of different forms of liquidity self-insurance in mitigating this effect.

Our study uses quarterly US data covering 80 downgrades during the Crisis to examine their impact on bank funding and domestic and foreign lending. Bank funding is categorised into core (demand deposits, money market funds, insured time deposits, and insured brokered deposits) and non-core (uninsured time deposits, deposits in foreign offices (foreign deposits) not covered by US deposit insurance, and wholesale funding in the form of fed funds purchased and repos).

Effects of rating downgrades on access to funding

The main results are threefold. First, banks that experience a credit rating downgrade also suffer from a simultaneous and persistent decline in access to non-core sources of deposits and to wholesale funding. This, in turn, translates into a significant reduction in both domestic and foreign lending. However, the transmission of liquidity shocks to loan supply is tempered if the bank initially holds a larger buffer of liquid assets, and contagion abroad is curbed when foreign subsidiaries of the downgraded bank rely on local deposits rather than on their parent bank for raising funds. Figure 1 shows the average effect of a credit rating downgrade on core and non-core funding for different initial credit ratings. The largest effects coincide with a bank being downgraded from investment grade to speculative grade (from above BBB+ to BBB or below) and falling below speculative grade (from BB to B). The fact that the effect is non-linear is consistent with anecdotal evidence that wholesale lenders use rating triggers in loan covenants.

Figure 1. Average effect of a credit rating downgrade on core and non-core funding for different credit ratings

Notes: The dashed lines are 95% significance intervals. Solid lines are average estimated effects.

Most forms of deposits and wholesale funding are insensitive to a downgrade except for fed funds (i.e. unsecured interbank funding) and foreign deposits, which are significantly lower for banks that are downgraded compared to control (not downgraded) banks. We also find a significant decline in access to non-core funding during and after Q4-2008 but not before, indicating a greater sensitivity of investors to downgrades during turbulent times. In sum, a credit rating downgrade is associated with a persistent decline in uninsured deposits and wholesale funding, particularly when wholesale markets are under stress and co-insurance breaks down.

Transmission of funding shocks to domestic and foreign lending

Next, we analyse the transmission of the downgrade-related funding liquidity shock to domestic and foreign lending. We find that the decline in lending increases in statistical and economic significance for banks holding a lower-than-median buffer of liquid assets and for those with a higher-than-median reliance on credit-rating-sensitive sources of funding (namely, uninsured time deposits and wholesale funding). Further, by separating liquidity constrained from unconstrained banks, a credit rating downgrade is associated with a decline in lending only for banks that have a high reliance on credit-rating sensitive sources of funding and only in the post-Lehman period. Thus, the decline in access to external funding associated with a credit rating downgrade translates into a significant decline in domestic lending to the extent that banks are not self-insured by holding higher buffers of liquid assets. Similarly, the decline in foreign lending is more pronounced for constrained foreign subsidiaries that do not strongly rely on host country deposits. Thus, funding self-sufficiency of the foreign subsidiaries (when foreign subsidiaries raise funds independently of their domestic parent) limits contagion across borders, allowing banks to sustain lending to the real economy in the host country when there is a crisis at home.

Internal liquidity support measures

Last, we develop a framework to assess the role of internal capital markets in the propagation or the containment of funding liquidity shocks. We explore the relevance of the activation of three internal liquidity support measures – net downstream loans (from parent to subsidiary), capital injections from the parent to its subsidiaries, and net loans from the domestic parent to its foreign subsidiaries – in response to a reduced access to external funding. These internal liquidity support measures are particularly relevant at top-rated banks, but not for more vulnerable banks with ratings of A- or lower. However, the activation of such measures is not large enough among the most constrained banks to offset the decline in external funding and to halt subsequent declines in bank lending.

The findings thus confirm that liquidity regulation is important to curb the real cost of liquidity crises. By maintaining adequate liquid buffers, banks are able to better withstand liquidity shocks and maintain the flow of credit to the economy. However, applying liquidity regulation uniformly to all banks can be less than optimal in the case of top-rated banks having in place an efficient centralised liquidity management system, which may be able to direct liquidity where it is most needed within a banking group and mitigate the effects of a liquidity shock while holding a smaller buffer at the banking group level.

Concluding remarks

The results lend support to proposals for subsidiarisation (placing high-risk bank activities in a separate legal entity), ring-fencing (structural separation of activities for retail banks), and tightening local liquidity for foreign bank operations. They also draw on the potential benefits of macroprudential policies imposing a levy on wholesale funding for large or too-big-to-fail banks that have increasingly relied on non-traditional sources of funding to expand activities. Last, we do not find that a higher capital ratio (unlike a higher liquid buffer) helps mitigate the real impact of a credit rating downgrade, which underlines the complementarity between capital and liquidity regulation.


Acharya, V and B Tuckman (2013), “Unintended Consequences of LOLR Facilities: The Case of Illiquid Leverage”, Presented at the 14th IMF Jacques Polak conference in honour of Stanley Fischer, October.

Armentier O, E Ghysels, A Sarkar, and J Shrader (2011), “Stigma in Financial Markets: Evidence from Liquidity Auctions and Discount Window Borrowing during the Crisis”, Federal Reserve Bank of New York Staff Report 483, January.

Karam, P, O Merrouche, M Souissi, and R Turk (2014), “The Transmission of Liquidity Shocks: The Role of Internal Capital Markets and Bank Funding Strategies”, IMF Working Paper 14/207. 

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