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A new house for sovereign ratings

Rating sovereign entities is too serious a matter to be left to private credit rating agencies. Their repeated blunders, and an abiding belief in a certain development model, has generated a debate on the need to create alternative structures, even going to the extent of, perhaps, establishing a multilateral solution.

The controversy focuses on the capability of private credit rating agencies (CRAs) to evaluate sovereign finances, given their well-known and extensively documented rating missteps in the private sector. The most glaring example is the AAA ratings given to flawed mortgage-backed securities in the U.S, thereby deliberately suppressing inherent risks from the investing public.

This wilful negligence was one of the factors behind the financial crisis that has gripped the global economy since 2008. The Financial Crisis Inquiry Commission in the U.S. inferred in its final report: “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction.” [1]

Consequently, there was an uproar and demands – including demands from multilateral bodies like the G20 – for regulating the rating agencies. A framework has since been created by the International Organisation of Securities Commission. It does focus regulatory attention on some of the contentious issues – such as a lack of adequate internal controls or an inherent conflict of interest that led to the 2008 financial crisis. But it fails to comprehensively reform credit rating as a financial service that can capably rate sovereign finances.

Allowing the current crop of CRAs to continue rating the creditworthiness of nations has numerous drawbacks.

The first problem is with the methodology. There have been criticisms that the rating process is driven only by balance-sheet considerations, without taking into account many unquantifiable factors that make sovereigns unique social or political organisations.

However, even if we accept the argument that rating exercises have a specific objective of assessing a sovereign’s creditworthiness and ability to repay commercial loans, the methodology for assessing political risks still raises some questions. For example, Standard & Poor’s (S&P) methodology for assessing political risks accords the highest marks to the following criteria:

1. Proactive policy-making, with a strong track record in managing past economic and financial crises, and delivering economic growth

2. Ability and willingness to implement reforms to ensure sustainable public finances over the long term

3. High likelihood that institutions and policies will remain stable over time, ensuring the predictability of responses to future crises. [2]

Some of these benchmarks can result in subjective outcomes.  For example, another criterion which gets countries the second-best rating states: “Weaker ability to implement reforms, due to a slow or complex decision-making process.” There are two undefined terms here: what does S&P mean by “reforms”? The term has different connotations for different demographic segments, or even different interest groups. And, does parliamentary democracy – in which debate and dissent are essential components – qualify for “slow or complex decision-making process”?

S&P admits that the process is qualitative, and is complemented by reports from the World Bank, the International Monetary Fund and the United Nations. Given the global opprobrium reserved for the worldview practised by these institutions, some of that censure is now rubbing off even on the CRAs.

Another compelling reason for thinking beyond the current crop of CRAs is the fact that they are all owned by private corporations, which are listed on the stock exchanges and are subject to pressures from boards and shareholder groups. S&P is owned by McGraw Hill, Moody’s Corporation is listed on the New York Stock Exchange, and Fitch is owned jointly by Hearst Corporation – a diversified media, entertainment and real estate group – and Fimalac, a French real estate and entertainment company.

It is also significant that all these companies, which are purportedly global, are located in New York. The location, as well as the diversified ownership structure of the rating companies (or their parent companies), make them also vulnerable to pressure from political forces, and amenable to the ideological currents dominating the narrative in the U.S. at any given point of time. For example, pressure was used against S&P when it downgraded the U.S. from AAA to AA+ in 2011. Eventually, S&P admitted it had made a mistake, restored the U.S.’s ratings, and replaced CEO Deven Sharma who, ironically, had been brought in to purge the agency of its pre-crisis ills.

The other obvious concern is a conflict of interest, especially between the parent organisation and the CRA. Another well-acknowledged source of conflict is inherent in the “issuer-pays” model. The U.S. Senate’s report on the financial crisis is unequivocal about the conflict: “The result is a system that creates strong incentives for the rating agencies to inflate their ratings to attract business, and for the issuers and arrangers of the securities to engage in “ratings shopping” to obtain the highest ratings for their financial products. The conflict of interest inherent in an issuer-pay setup is clear: rating agencies are incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business.” [3]

The solution could be to create a completely new structure for sovereign ratings. While existing CRAs can continue to rate private sector paper within the expanded and reinforced regulatory framework, sovereign ratings need a new house.

Many alternative solutions have come up.  One is to bring private CRAs under public control. [4] Former diplomat Jaimini Bhagwati has also suggested that the Indian government launch a public sector CRA. [5] However, such a structure will also be susceptible to fault-finding, especially when rating paper that is issued by government companies.

Another suggestion is that BRICS nations launch their own rating agency, which will be sensitive to the unique political, socio-economic and development models of emerging nations. [6] But this can be, at best, a regional rating agency; it will not be globally acceptable.

The only real solution is to make an independent multilateral institution, such as the Multilateral Investment Guarantee Agency, the sole sovereign rating agency in the world. The Agency will, of course, have to be unmoored from its current World Bank ties (especially in the selection of its CEO) and relocated out of Washington D.C. to a site which is neither in the U.S. nor in Europe, because location eventually does have an influence on ideology. The world desperately needs a truly independent CRA, which is not swayed by popular western political dogma.

S&P’s letter to Gateway House (27 March 2014, Surinder Kathpalia, Managing Director, Head of South and Southeast Asia, Standard & Poor’s Ratings Services)

While we welcome scrutiny and debate about credit ratings, Rajrishi Singhal’s article “A new house for sovereign ratings” (March 20, 2014) perpetuates a number of myths and misconceptions about ratings agencies – and about sovereign ratings in particular.

Contrary to Mr. Singhal’s suggestions and similar claims at the time by the U.S. government, there was no “error” in Standard & Poor’s analysis when it lowered the U.S. sovereign rating in 2011. We have said publicly that we adjusted our assumptions before announcing the new rating, but that this had no impact on our decision.

In fact, Standard & Poor’s own track record of credit ratings as indicators of sovereign default risk is very strong. The relative rank-ordering of sovereign ratings has been consistent with historical default experience – and a 2010 study by the International Monetary Fund (IMF) report found that all sovereigns that have defaulted in the last 35 years had sub-investment grade ratings at least a year before default.

Mr. Singhal also overlooks that ratings agencies have been brought under regulation in most major markets over recent years. This new regime has helped increase the oversight, transparency and accountability of ratings worldwide. Separately, Standard & Poor’s has taken numerous of its own steps since the financial crisis to further strengthen our systems, governance, analytics and methodologies.

Regarding rating agency business models, almost every recent independent review of this issue has concluded that no model is immune from potential conflicts of interest. We believe that the issuer-pays model – with conflicts properly managed – is the best available model because it enables us to provide ratings simultaneously to all investors free of charge and maximizes public scrutiny of ratings.

Analytic independence has always been a core principle of S&P’s ratings process. We have long had policies in place to manage potential conflicts of interest, including a separation of analytic and commercial activities.

At Standard & Poor’s, our mission is to provide independent credit opinions to the market. Investors value the independence, transparency and comparability of the ratings and research produced by our more than 1,400 analysts worldwide.

Finally, we disagree with Mr. Singhal’s proposal to replace competing ratings agencies with a single provider of sovereign ratings, such as the Multilateral Investment Guarantee Agency. We believe the market benefits from a diversity, rather than monopoly, of views on credit risk and that investors should be free to decide which ratings providers, regardless of their business model, are credible and useful.

Gateway House responds (16 April 2014, Rajrishi Singhal, Senior Geoeconomics fellow, Gateway House)

Mr. Kathpalia’s rejoinder overlooks the central theme of the article: how credit rating agencies (CRAs) might have lost the intellectual authority to rate sovereign debt, though the numerous rounds of regulatory tightening by various regulators (such as IOSCO globally, European Securities and Markets Authority in Europe, SEC in USA, or Sebi in India) might still help them continue rating private sector debt.

Our responses to your letter are as below:

1. Regarding the issue of S&P’s “error” in its calculations while downgrading U.S.’s credit rating in 2011. Mr. Kathpalia adds that S&P only “adjusted” its assumptions and that never influenced its rating decision.

GH: An S&P press release dated August 19, 2011 — actually a corrected re-issue of an earlier release (dated August 6, 2011) — admits to the error in the Editor’s Note prefacing the actual press statement: “The projected debt numbers in that statement (a reference to the earlier document) were correct, but the difference between the two approaches is smaller than the incorrect dollar figure previously provided as a result of an editing error. In the version below, we have revised that dollar figure and have provided the actual debt numbers in nonrounded (sic) terms.” The body of the statement further discloses that a subsequent change in methodology resulted in U.S.’s long term debt estimates actually shrinking by $2 trillion (the “error”), but that had little bearing on the rating decision.

There were numerous articles in leading newspapers, soon after downgrading of U.S.’s credit rating, which show that S&P — or senior S&P officials — had initially admitted to an “error” but later changed the statement. In a widely-quoted piece in the Wall Street Journal on August 7, 2011, the following assertion became the source material for numerous subsequent articles: “S&P officials acknowledged the error Treasury pointed out but didn’t believe it was so significant. It was a technical error, though it could have serious implications. It concerned the future ratio of U.S. debt to the size of the economy, with S&P officials projecting a larger share than many experts.”

An internal report from the Congressional Research Service dated August 9, 2011 also quotes the same Wall Street Journal article.

In a primer on credit rating, the Council on Foreign Relations also states that S&P admitted to a $2 trillion error.

2. Mr. Kathpalia states this author has overlooked the increased regulatory gaze now focussed on CRAs, and how CRAs — particularly S&P — have strengthened their “systems, governance, analytics and methodologies.”

GH: This is largely true and the Gateway House article also agrees. However, while the regulatory tightening may have achieved some partial results (“partial” because it’s still too early to say with certainty whether the regulatory design is completely efficacious), and it may be just suitable for the private sector, the focus of the article is on whether these regulatory actions have improved CRA capability for rating sovereigns. The answer, in my view, remains in the negative because the rating process for sovereigns is still one of subjectivity, the rating criteria is open to flexible interpretation and, seemingly, provides space for only a particular political ideology. This is well-documented: Nobel Laureate Paul Krugman has eloquently shown how S&P’s downgrade of France in 2013 was more political, less fiscal.

The European Securities and Markets Authority (ESMA) recently conducted an investigation into sovereign ratings by CRAs. The report, published in December 2013, found many deficiencies and grounds for concern, as well as infringements of existing regulations. Among the many shortcomings it lists, three merit mention here: CRA board members trying to influence rating committee decisions, a considerable time lag between a rating committee decision and publication of the sovereign rating, disclosure of upcoming sovereign rating actions to unauthorised third parties (sometimes even before meetings of the rating committees).

There are numerous other studies which show how politics can influence sovereign ratings. Andreas Fuchs & Kai Gehring show how sovereign ratings exhibit home country bias of rating agencies.

3. Mr Kathpalia disagrees with the article’s concern over the rating agency business model, which is believed to be conflicting and severely compromised. Mr Kathpalia says the issuer-pays model is the “best available model”, provided the conflicts are managed.

GH: There is enough empirical evidence to show how business conflicts find ingeneous and innovative ways to work around regulatory bounds. There are numerous studies, as well as a study by the US Senate Permanent Sub-committee on Investigations (quoted and cited in the article), which probed the likely causes behind the financial crisis and found the issuer-pays model as a vital reason behind the rating missteps, leading to the financial crisis.

4. Mr. Kathpalia objects to the article’s suggestion that the Multilateral Investment Guarantee Agency of the World Bank Group “replace competing ratings agencies with a single provider of sovereign ratings”, thereby installing a monopoly regime compared with the diversity of choices available now.

GH: I concur with Mr. Kathpalia’s concerns about dismantling the current oligopolistic market with a single rating agency. The point our article was making was that sovereign ratings should no longer remain in the control of New York-centred private companies that are amenable to varying pressures and ideological biases, but should be vested with reliable, independent, non-U.S. based multilateral agency/agencies.

Rajrishi Singhal is Senior Geoeconomics Fellow, Gateway House.

This article was exclusively written for Gateway House: Indian Council on Global Relations. You can read more exclusive content here.

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[1] Angelides, P. National Commission on the Causes of the Financial and Economic Crisis in the United States, (2011). The financial crisis inquiry report. Retrieved from U.S. Government Printing Office website http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf

[2] Standard & Poor’s. (2011). Methodology: Assessing the five main sovereign rating factors. Sovereign Government Rating Methodology And Assumptions, 10. Retrieved from http://www.standardandpoors.com/spf/upload/Ratings_EMEA/2011-06-30_CBEvent_CriteriaGovSovRatingMethodologyAndAssumptions.pdf

[3] Levin, C. United States Senate, Permanent Subcommittee on Investigations. (2011). Wall Street and the financial crisis: Anatomy of a financial collapse. Retrieved from  http://www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf?attempt=2

[4] Gavras, P. (2013, March). Ratings game. Retrieved from http://www.imf.org/external/pubs/ft/fandd/2012/03/pdf/gavras.pdf

[5] Bhagwati, J. (2008, November 21). ‘Public sector credit rating agencies?’ Business Standard. Retrieved from http://www.business-standard.com/article/opinion/jaimini-bhagwati-public-sector-credit-rating-agencies-108112101037_1.html

[6] The Brics Post. Brazil, India, SA part of new global ratings agency. (2013, November 12). Retrieved from http://thebricspost.com/brazil-india-sa-part-of-new-global-ratings-agency/