The Damaging Bias of Sovereign Ratings

Abstract

Sovereign credit ratings guide over USD 50 trillion in outstanding sovereign debt and set the ceiling for most corporate credit ratings. The credit rating agencies assign ratings based on a combination of objective fundamentals and the subjective judgment of their in-house rating committees. In this paper we decompose the sovereign ratings of the 'Big Three' rating agencies into an 'objective' component (the fitted value from an OLS regression of ratings on 10 explanatory variables) and a 'subjective' component (the corresponding residuals) using data for advanced and emerging economies over the period 1996-2013. We then examine the explanatory power of the two components for predicting sovereign default. Our main finding is that, while the 'objective' component has explanatory power to predict defaults both in the short and long-term, the 'subjective' component does not help to predict defaults of a horizon of 1 year or more. In particular, analysing the probability of default within 3 years, we find the 'subjective' component is biasing default predictions in the wrong direction with-at times-dramatic consequences. This is the 'damaging bias' of sovereign ratings. The biggest casualty of this was the Eurozone periphery, which was downgraded far too heavily during the 2009-2011 sovereign debt crisis as the rating committees repeatedly overruled the signal coming from fundamentals. In light of our findings, we suggest that credit rating agencies should be stripped of their regulatory powers and these transferred to an international body. Failing that, the ratings agencies should be forced to substantially increase transparency, including publishing a separate breakdown of the 'objective' and 'subjective' components of ratings, the minutes of the rating committees, and the voting records.(J.E.L.: G24, F34, H63, F65).

Euro Area Sovereign Ratings: An Analysis of Fundamental Criteria and Subjective Judgement

“…Similarly, focusing on the euro area crisis, Vernazza and Nielsen (2015) decompose the sovereign ratings of the 'Big Three' rating agencies into an 'objective' component (the fitted value from an OLS regression of ratings on 10 explanatory variables) and a 'subjective' component (the corresponding residuals) using data for advanced and emerging economies over the period 1996-2013. Their main finding is that, while the 'objective' component has explanatory power to predict defaults both in the short and long-term, the 'subjective' component does not help to predict defaults over a horizon of one year or more.…”

“…However, CRAs should be much more transparent in showing to what extent their ratings are driven by their models or opinions. Specifically, and along the lines of Vernazza and Nielsen (2015), we recommend that for each sovereign, CRAs publish two ratings, namely, i) a purely quantitatively derived rating -reflecting publicly available data on macro-economic, institutional and public finance fundamentals combined with fully transparent methodologies so as to allow policymakers and market participants to calibrate each agency's 'fundamental' rating themselves, and ii) a final rating, which includes the CRA's judgements and opinions which policymakers and market participants may or may not agree with.…”

“…al. 2004), guide about USD 50 trillion in outstanding sovereign debt (Vernazza and Nielsen, 2015). In addition, as CRAs usually apply 'sovereign ceilings' to their assessment of local securities or entities (local governments, financial institutions, corporates and structured finance products), sovereign ratings serve as a benchmark for all other credit ratings, and thus, their relevance and systemic effect for the capital markets goes beyond the sovereign debt markets (ESRB 2015).…”

“…We use the same key asVernazza and Nielsen (2015) to convert alphanumeric ratings into numbers (Appendix B).26 We compute the correlation between the 19 ratings of two agencies at each point in time (end of each quarter). 27 Over the observed period, the widest rating divergence was for Slovenia from Q2 2013 to Q4 2014 when S&P, Fitch and Moody's rated the sovereign 'A-', 'BBB+' and 'Ba1' respectively.…”

The Fiscal-Monetary Policy Mix in the Euro Area: Challenges at the Zero Lower Bound

“…This phenomenon was documented by a diverse set of studies including Aizenman, Hutchison and Jinjarak (2013), DeGrauwe and Ji (2013), andVernazza and Nielsen (2015) Delatte, Fouquau and Portes (2016). document an increased sensitivity to fundamentals from 2010 to 2012, and a partial reversal following the introduction of the OMT by the ECB.…”