Does sovereign creditworthiness affect bank valuations in emerging markets?

•We examine the impact of rating actions on bank valuations in emerging markets.•We find strong evidence of a rating channel from sovereigns to banks.•Collateral and guarantee channels play modest roles.•Positive sovereign actions by S&P have the strongest impact on bank valuations.•Changes in sovereign ratings have a significant effect on banks’ valuations.

We analyse the impact of sovereign rating actions by S&P, Moody's and Fitch on bank valuations in emerging markets. We find strong evidence of a rating channel for the transmission of sovereign risk to bank valuations. Collateral and guarantee channels play modest roles, but are more relevant to countries that experienced positive actions. Positive sovereign actions by S&P have the strongest impact on bank valuations. Both negative and positive new rating information, outlook and watch actions are associated with strong market impact. The findings identify clear evidence of links between emerging market governments’ external credit standing and banks’ market valuation.