Foreign banks and sovereign credit ratings: Reputational capital in sovereign debt markets

Abstract

Sovereign credit ratings importantly influence the borrowing costs of governments in international capital markets. Yet, there is limited understanding of how credit-rating agencies determine sovereign bond ratings. I provide theoretical justification and empirical evidence to support the proposition that a substantial presence of established global banks, acting as foreign direct investors, enhances the perceived creditworthiness of the host countries that have weak domestic institutions. Foreign banks can render the host countries’ commitments to make good on their debt obligations more credible by encouraging the transparency in the financial system, disciplining their fiscal policies, and mitigating the incentives for and impact of bank bailouts. Statistical evidence from countries in emerging Europe shows that countries with high levels of foreign bank ownership tend to be assigned better sovereign credit ratings and find it easier to obtain credit at lower interest rates in sovereign bond markets. My findings are robust to various estimation techniques, to extensive controls for alternative determinants of credit ratings, for the endogeneity of foreign bank entry, and for sample-selection bias. Interviews with bankers and senior analysts at credit-rating agencies were used to complement quantitative analyses. This article is the first attempt in the literature on sovereign borrowing and debt to examine whether private market agents, such as global banks, can enhance the government’s international creditworthiness.