New regulations needed to limit impact of favouritism on country credit ratings
By: Communications
Professional connections between government ministers and top executives at credit ratings companies can influence the financial ratings for those countries, according to new research.
The study, by economists at the University of East Anglia, Heriot-Watt University and Bangor University, found links between finance ministers and executives at the biggest credit ratings agencies were associated with higher ratings than for countries without these connections.
The researchers attribute this to ‘favouritism’, stemming from a conflict-of-interest problem in the credit ratings agency (CRA) business model. They say the relationship could be the result of a ratings agency executive and finance minister having ongoing or past professional connections, for example having worked together in the same organisation.
The study, published in the Journal of International Financial Markets, Institutions & Money, is the first to look at professional connections at the country level (politicians & top executives) as opposed to company level (top executives & top executives) and whether it can affect a country’s ability to borrow.
The researchers say the professional connections, part of a rating’s ‘soft’ component, which is not related to fundamentals such as GDP, inflation and unemployment, are as important in rating process.
They find these benefit developing countries more than developed countries, as they might normally receive lower ratings. They also highlight the practice - and problem - of countries “soliciting”, or paying, for ratings, with those that do receiving higher ones than those that do not.
Lead author Prof Patrycja Klusak, of Heriot-Watt University, conducted the research while at UEA’s Norwich Business School and is an affiliated researcher at Cambridge’s Bennett Institute for Public Policy. She said the findings have wide-ranging implications for regulators, governments, market participants and CRAs, as well as being of interest to voters during election periods, as news about a country’s financial health “infers the quality of incumbent governments”.
“The ratings applied to a country’s financial health are hugely important because they help that country – and its banks and businesses – to access capital and borrow money at affordable rates,” said Prof Klusak.
“They also underpin direct investment flows into big national projects and affect the efficiency and stability of capital markets across borders.
“If ratings agencies are consciously or unconsciously inflating their ratings of particular countries, it’s a problem, because for financial markets to work properly, buyers of government debt need to know the true creditworthiness of that country.”
Sovereign credit ratings help investors understand the risk levels of investing in a country’s debt. The higher the rating the more likely it is that the sovereign country is going to be able and to be willing to pay back their obligations.
Countries have a strong incentive to receive favourable ratings as they also determine the cost of borrowing at a corporate level, with a cap on the ratings of other institutions within the country, for example banks, and knock-on impacts for anyone with products such as a mortgage or pension.
The European sovereign debt crisis of 2010–12 exposed the risk of excessive national borrowing fuelling a collapse in confidence that can spill over into other countries and their corporations, banks and financial assets.
European regulators scrutinised ratings agencies in the aftermath, particularly the conflict of interest when countries pay agencies to rate them, and get a seat on ratings agency committees as a result.
The study, co-authored by Associate Professor Yurtsev Uymaz of Norwich Business School and Prof Rasha Alsakka of Bangor Business School, used data on professional connections between financial ministers and top executives from three rating agencies – S&P, Moody’s and Fitch.
It looked at the connections for 38 countries in Europe between January 2000 and November 2017. They find that for developed countries these connections can result in higher ratings by an average of between one to two-thirds of a notch on the scale of credit ratings for S&P, Moody’s and Fitch. For developing countries, the increase is seven, two and four times bigger than the equivalent for developed countries.
Dr Uymazb said: “Our study offers an important contribution since credit rating agencies inherently suffer from ‘conflicts of interests’ in the rating model. This is because their customers are the same parties/issuers who pay for ratings, and we show that unsolicited sovereign ratings are significantly lower than solicited ratings.
“The conflict can happen at the company level and individual level. We need new rules to ensure that sovereign ratings are objective and independent from the rating of other asset types, like corporate loans, to avoid such conflicts of interest.”
The authors also highlight the “immense pressure” ratings teams face to release ratings which might bring in other business from that country – for example from its corporations and financial institutions, saying working conditions should also be improved.
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