The Impact Of Credit Ratings On The Financial Markets

Standard & Poor’s recent downgrade of Turkey’s credit rating triggered fresh volatility in the country’s financial sector, with stocks and bonds tumbling on fears of further downgrades following President Recep Tayyip Erdogan’s three-month state of emergency. The move came just days after Moody’s Investors Service said it would put the country’s credit rating on review. 

The impact of credit ratings on the financial markets is not always easy to understand or predict. Since the fallout of the 2007-2008 subprime mortgage crisis, it became clear that a serious overhaul of the credit rating system was required. The “Big Three” global credit rating agencies – Standard & Poor’s, Moody’s and Fitch Ratings – faced intense scrutiny for their failure to provide reliable information on the level of risk associated with various types of debt.

As a result, the 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act and 2011 European Securities and Markets Authority have both mandated reforms to hold credit rating agencies accountable. The credit rating agencies themselves have also faced growing legal battles. For Standard & Poor’s, this resulted in a record $1.37 billion settlement in 2015. 

The impact of credit ratings on the markets has been studied at length by banks, investors and even governments. The European Central Bank (ECB), for instance, has found that investors typically react to changes in credit ratings if they are unexpected. In this way, credit ratings behave in a similar fashion to other types of new information, such as economic data or corporate earnings that diverge from the consensus forecast.

According to the ECB, bond rating downgrades in particular “percolate from the affected company to its rivals, and from the bond market to equity prices.”

The Bank added, “The price reaction to rating changes, and in particular the effect on stock returns, is asymmetrical. “The market reacts more strongly to rating downgrades than to rating upgrades, and ultimately this asymmetry appears less significant for bonds than for stocks.”