The agencies correctly identified low domestic savings and poor economic competitiveness, related more to low productivity than to high costs per se, as the roots of the country's low trend growth rate. Downgrading did not exceed two notches at that time. Interest spreads declined after the first round to about 0. This round was triggered less by market pressure than by political uncertainty, resulting in a government crisis as a consequence of the failed austerity programme.
The interim government's limited capacity to act challenged a timely support by a hesitant EU and IMF. Moody's optimistically justified the limited April downgrade to 13 and not lower by arguing that assistance would be provided by the other members of the eurozone if Portugal needed financing on an expedited basis before it could obtain funds from the European Financial Stability Facility, and that the new government would approach the facility as a matter of urgency.
Both aspects, announced after a meeting of European leaders in Brussels on 25 March, are "detrimental to commercial creditors. It is interesting to note that in each month from December to March at least one RA downgraded: The spreads, however, did not rise but instead fluctuated around 3 pp. Moody's said the motive behind the downgrade was the growing risk that Portugal would require another round of financing from its European neighbours, with funding from the private sector a precondition. Ireland had a top rating of 20 from late to spring The first round of downgrading in spring resulted from the agencies' surprise that the fiscal cost to the government of supporting the Irish banking system would turn out to be significantly higher than they had expected.
Unfavourable business cycle forecasts contributed as well. Until spring it shrunk to 1 pp; problems had apparently calmed down. The second round, characterised by multi-notch downgrades 63 starting in autumn , followed a tripling of spreads to about 3 pps. It had as its starting-point the crystallisation of bank-related contingent liabilities, the increased uncertainty regarding the country's economic outlook and the decline in the Irish government's financial strength - facts, however, which were not new but had existed for quite a while.
Irish borrowing costs initially rose after the bailout was agreed but declined afterwards. The ratings declined to in spring In April Fitch said that the "Irish economy appears to be nearing stabilisation and the latest efforts to resolve the banking crisis are credible". Spain's sovereign rating was continually upgraded until all RAs agreed on 20 in late One-notch downgrades by all three RAs reflected their view that the process of adjustment to a lower level of private sector and external indebtedness would materially reduce the rate of growth of the Spanish economy over the medium term.
Surprisingly, none of the RAs worried about the Spanish housing and construction crisis. The OECD, in contrast, was severely concerned about "construction Fitch said that its negative outlook reflected the downside risks to Spain's sovereign credit profile from a weak economic recovery, banking sector restructuring and fiscal consolidation, especially by regional governments.
As in the other countries, the rating reflects the market's assessment: The justifications for downgrading these three countries differ from those given by Cantor and Packer 66 as well as from those found for Greece. The fiscal cost of restructuring the financial sector was by far the dominant triggering element for Ireland 11 out of 21 statements and one of three important elements for Spain, the other two being its budget deficit and low growth in each case 3 out of For Portugal's downgrades, the country's lack of fiscal discipline 5 out of 17 , low growth expectations 4 and structural problems were mentioned most frequently.
Credit Ratings | The Linde Group
The study has dealt with the sovereign ratings of the big three RAs, not with their other, quantitatively more important business of rating securities. While the literature offers some evidence of manipulating the rating of securities, especially structured finance obligations, few indications of excessive sovereign downward rating could be detected. June was the only exception, when two RAs threatened to downgrade Greece and potentially Portugal to insolvency status if private creditors participated in the losses, whether forced or willingly. Even in this case, the problem is less the level of the rating so much as the attempt to force policy.
That the RAs would display different behaviour in the two markets is not implausible. In security rating the debtor, who is naturally interested in the highest possible rating, pays for the rating, and the competition for customers cautions the RAs not to be too strict. A clear conflict of interest exists. By contrast, in sovereign rating the potential creditor pays for the full-length rating report , and he is interested in a stricter rating.
One should therefore expect overcritical sovereign ratings, and this is what media and politicians blame the RAs for. The outcome of this study suggests that just the opposite is true: However, nothing suggests the RAs would benefit from such a benevolent stance; more likely they were caught by the problems and uncertainties of forecasting resulting from the at the time barely understood mechanisms of a currency union without a political union. Uncertainties as to the real effectiveness of the no bail-out clause appear to have combined with traditional forecasting errors - pro-cyclicality, turning-point mistakes, underestimation of change and the potential to adjust, disregard of political elements, and an incapacity to deal with surprises shocks.
The abrupt change from underreaction to overreaction was caused by the late, reluctant and contentious support from the EU and the IMF and their unrealistic assumption of achieving market financing within one year. Furthermore, RAs appear to have given too much weight to financial indicators and not enough to the underlying real problems.
Greece's dramatic decline in the financial markets was caused only to a very limited extent, if at all, by its ratings. The main reason was a series of policy failures 67 , by both the Greek and the EU governments. Greece's unjustified accession to the monetary union, problems in solving structural deficiencies and political discrepancies gave rise to burgeoning debt levels. When it came out that the government had falsified statistics before and after joining the monetary union and the country's finances were even worse than perceived, interest spreads rocketed and market access was denied even quantitatively.
It took extremely long to come to an agreement, and as a result the next rescue operation became unavoidable before the first one had even been completed. The support was a political compromise 68 , offering too little to survive and too much to die immediately. Contrarily, the austerity program was overambitious and so strict that political unrest, even a fall of the government, was an almost certain consequence. The policy failure received its drama through the institutional failure of having granted regulatory power to private rating agencies.
One may debate whether it is appropriate that rating agencies, by rating securities, control private banks' portfolio compositions, given the assessments' limited accuracy. But it is strange indeed that the European Central Bank, which places great emphasis on its political independence, allows its refinancing conditions for banks to be controlled by private companies - the ECB's rules prevent it from accepting 0-rated securities as collateral.
The solution, therefore, is not to gain some control over the RAs' sovereign ratings or even to found a European RA which is a highly unrealistic proposal but rather to revoke the RAs' control of the central bank's actions. Endspiel um den Euro, in: Die Presse, 18 June , p.
Die Presse, 16 June , p. Default, currency crises, and sovereign credit ratings, , http: Reinhart , op cit. To err is human: Determinants and impact of sovereign credit ratings, in: The New Basel Capital Accord: The credit rating industry: An industrial organisation analysis, in R.
Ratings, rating agencies and the global financial system, Boston , Kluwer. The alchemy of CDO credit ratings Sovereign bond yield spreads: Asset prices, financial and monetary stability: War die Finanzkrise vorhersehbar? Perspektiven der Wirtschaftspolitik, Vol. Why did policy ignore the harbingers of the crisis? Hellmayer , quoted in: The Greek financial crisis: Growing imbalances and sovereign spreads, Bank of Greece Working Paper , Bofinger added that nobody should be amazed about the markets being flushed out if the eurozone governments carry out all there conflicts publicly and the ECB threatens doomsday scenarios, in: Rating agencies continue to be in the eye of the storm.
After being singled out very early on as contributors to the subprime bubble, they have continued to be criticised ever since. In the meantime, however, an EU regulation has been adopted and already amended once, and discussions are ongoing regarding a further amendment. The persistence of the criticism seems to indicate, however, that the problems have not been solved by the proposed solutions.
Rating agencies are considered to be an essential element of a well-functioning capital market. They are reputational intermediaries between issuers and investors, along with brokers, analysts, audit firms, financial journalists and self-regulatory organisations. The rating agency industry originated in the context of the growth of the capital market driven model in the USA.
We would argue that EU policymakers should stop criticising the industry and instead apply the regulation in a manner that works before changing it again. They should urgently work on eliminating references to the CRA ratings in other pieces of regulation and stimulate new market entry and thus not create a publicly funded agency. Supervisors should not insist on the protectionist elements in the EU regulation but check whether the market is competitive.
Rather than allowing the industry to make claims to "free speech", they should insist on the liability of rating agencies when adopting certain positions. The rating agencies were one of the first policy victims of the financial crisis. Even before the collapse of Lehman, a strong consensus had emerged that the industry should be subject to statutory regulation.
A consultative document was circulated by the European Commission in July , and a regulation was formally proposed in November The regulation was adopted in six months, a record in EU policymaking. The debate on the appropriate policy framework for rating agencies considerably predates the financial crisis, however. Already in the Southeast Asia crisis, the late reaction of rating agencies to the public finance situations in these countries was strongly criticised. The same applies to the dot-com bubble in with regard to the ratings of corporations.
At the global level, in the IOSCO, the International Organisation of Securities Commissions, adopted a "Statement of Principles" on the role of credit rating agencies - without much success, apparently. In a Communication published in December , it decided that no legislation was needed for three reasons: The EU regulation The amendment gives the unique supervisory responsibility to ESMA, which had been created in the meantime, and imposes similar disclosure requirements upon issuers of structured finance instruments under the US SEC's Rule 17g The policymakers thus have a formidable instrument available to control the industry.
They can control the governance and business model. They can check for the competence of the employees and the appropriateness of their compensation. They can examine the existence of conflicts of interest and verify the methodologies applied. However, by the end of August , more than a year after the coming into force of the first regulation, only 10 of the 22 CRAs that applied had been licensed by ESMA, including none of the Big Three so far! ESMA may still be understaffed to deal with its new tasks, but EU policymakers could detach Commission officials to ensure rules can be applied if the sector is so high profile.
This would allow them to start making in situ inspections of the Big Three in case of disagreements with a sovereign downgrade, for example. This would also be helpful for new industry entrants. Several pieces of regulation have created a captive market for CRAs. This is not the case in the USA, as it has not implemented Basel II largely because the Federal Reserve did not want the vast majority of US banks relying on CRAs for setting regulatory risk weights and the discount window of the Fed is not based upon ratings.
In its standardised approach, to be used by less sophisticated banks, Basel II bases risk weightings for credit risk exposure on rating agencies' assessments. Basel II was implemented into EU law in as the capital requirements directive.
- The Communication Catalyst?
- Bond Ratings - Overview, Examples, List of Bond Rating Systems;
- The Historical Formation of the Arab Nation (RLE: The Arab Nation) (Routledge Library Editions: The Arab Nation)?
On the contrary, the reliance on the standardised approach may become even more prevalent, as the internal ratings-based approach has come under much criticism in the post-crisis context. The sector has already been raising this issue with the authorities for some time, but they have yet to act. In the USA, the Dodd-Frank Act June requires regulators to remove from their rules any references to, or requirements that depend upon, credit ratings.
In June , the Federal Reserve Board issued a report to Congress reviewing the subject and identified 46 references to credit ratings, the majority of which appear in capital adequacy measures for banks, such as risk weighting. The Fed concluded by saying it will propose amendments to remove references to credit ratings from its capital requirements and rely on substitute standards of creditworthiness for capital calculations that currently rely on external ratings.
CRAs thus have a dream market in the EU. They are in the news on a daily basis in the context of the sovereign crisis, and their use is obligatory under EU legislation. It is thus high time that EU policymakers emulate their US counterparts and eliminate the regulatory reliance on private credit ratings. Although it was feared that a formal licence would reduce market entry, this does not seem to be the case so far. Some 22 entities applied for an EU licence, including some unexpected newcomers such as credit insurance companies.
ESMA and competition authorities should thus carefully monitor how the market develops and whether the oligopoly of the Big Three diminishes. Two questions emerge in this context: This has been widely criticised as raising enormous conflicts of interests, but no change has been instituted so far, although other models have been proposed. A clearing house for ratings, whereby an intermediary independently decides who should do the rating, may help newcomers and at the same time reduces conflicts of interest.
Another element in the EU regulation restricts market entry but does so in a global context. It has been argued that this regime will unnecessarily fragment global capital markets. Foreign companies will be less inclined to raise capital in the EU, as they will need a local endorsement of their rating.
The regime could also be qualified as anti-competitive, as smaller CRAs without an EU presence may stop rating EU sovereigns and issuers. A final element to bring more competition to the sector is to increase CRAs' exposure to civil liability. Increasing the responsibility of CRAs may be especially constraining for the larger firms, as they have a strong market presence and have grossly failed in the past.
Report to the Congress on Credit Ratings, July What Reforms for the Credit Rating industry? A European perspective for an overview. Owain ap Gwilym and Rasha Alsakka. Nobody likes to be "downgraded" in any walk of life. It implies a decline or deterioration. When the downgrade relates to the credit standing of a developed country, one might naturally expect a hostile reaction and counter-criticism. In the case of credit downgrades, it is arguably a peculiar scenario whereby a private company has a potentially huge influence on a government's borrowing costs. CRAs have also faced criticism in the recent past with regard to their role in rating structured finance products in the context of the US subprime crisis.
This article focuses solely on sovereign ratings, with the aim of highlighting evidence on the behaviour of sovereign ratings and analysing whether recent critiques of CRA actions have a sound basis. Sovereign ratings represent a ceiling for the ratings assigned to non-sovereign issuers within a country. This was particularly problematic for several Greek, Irish and Portuguese banks, since their ratings were downgraded to speculative status. In addition, sovereign ratings contribute to the smooth and efficient working of the global sovereign debt market.
They also have a direct impact on a sovereign's cost of borrowing, and this is central to the question of whether CRA actions contributed to a worsening of the European sovereign debt crisis. The role of CRAs has expanded significantly during the last 20 years, whereby credit ratings are now heavily hardwired into investment processes, financial contracts and regulatory frameworks. Therefore, CRA news releases have potentially systemic consequences. Transient rating actions can be very harmful to the debt issuers and users of ratings, hence CRAs are well aware of the need to avoid reversals of actions.
To mitigate the stability-accuracy tension, credit outlook and watch are supplemental instruments used by CRAs to signal adjustments in their opinion of issuer credit quality. These instruments perform an important economic function, but are far too often overlooked by commentators when considering a CRA's actions and performance.
Many empirical studies have shown that outlook and watch signals are at least as important as actual rating changes in their market impact. In response to the perceived role of CRAs in the US subprime crisis, several policy actions have already occurred and new legislation has been passed in the United States and Europe. Many other G countries have introduced or are in the process of introducing new regulatory oversight for CRAs.
Further, the Basel Committee of the Bank for International Settlements reviewed the role of external ratings in the capital adequacy framework, mainly to incorporate the IOSCO Code into the committee's eligibility criteria, and to require banks to perform their own internal assessments of externally rated securitisation exposure.
Bond Ratings
The Financial Stability Board 7 published a set of principles for reducing reliance on CRA ratings in standards, laws and regulations. CRAs have been accused of precipitating the sovereign debt crisis by downgrading the ratings of eurozone sovereigns too far and too fast. Politicians across the EU have called for further regulation to improve quality and transparency in sovereign ratings. Proposals from European politicians have generated a mixed response, including the notion of a publicly owned rating agency and a suggestion that CRAs should notify sovereigns three days in advance of a rating event rather than the normal twelve hours.
A recent UK House of Lords report 8 argues that the criticisms are largely unjustified since rating downgrades reflect the seriousness of the problems faced by euro-zone sovereigns. It also encourages legislative changes to enhance the quality of national statistical data and advocates that sovereigns should cooperate with CRAs to ensure that their ratings are as accurate as possible.
Figure 3 presents the recent rating history for the four countries which have attracted the most attention during the European sovereign debt crisis, namely Greece, Ireland, Portugal and Spain. For this and later analysis in this article, we use a point numerical comprehensive credit rating scale CCR incorporating the actual ratings, the outlook and watch status, as follows: These plots illustrate differences of both opinion and timing across agencies.
At the time of writing, a significant difference of opinion has prevailed in relation to Ireland and Portugal. Moody's downgraded these two sovereigns' ratings to speculative status in July , while other agencies are still rating them as investment grade. It should be noted that despite huge media attention on Spain and Italy due to concerns over possible spillover effects arising from other "peripheral" countries of the eurozone, the rating actions for these countries have actually been modest.
Similarly, there has been widespread media speculation about the sovereign rating of France due to the exposure of French banks to foreign governments' debt, yet it has not been subject to a single rating action from any of the largest CRAs. The large and frequent downgrades during the recent time period have been restricted to the countries which have required international financial assistance programmes, i. Greece, Ireland and Portugal.
Figure 3 also shows that only few negative actions occurred before July , suggesting that the CRAs did not predict the public debt problems of these European countries at a very early stage. For example, Moody's did not change the positive outlook of Greece rated at "A1" until 25 February However, controversy over national economic data was another element in the unfolding of the crisis. The CRAs were no different to Eurostat, banks and others in seemingly being unaware of the full implications of the off-balance sheet vehicles and other manipulations used by Greece.
Some commentators have drawn on the analogy of the Trojan horse in reflecting on how Greece was permitted to join the euro. Subsequently, Greece was effectively "sheltering" within the eurozone and benefitting from far lower bond yields than would have been reasonable if the true picture of its indebtedness were revealed. The effectiveness of Greece's "commitment strategy" of being within the euro has been drastically undermined since the realisation of its true debt levels. A large number of academic studies over the last fifteen years have been able to explain the determinants of sovereign ratings and rating changes quite successfully.
It should be no surprise that per capita GDP, real GDP growth, government deficits and government debt levels are crucial variables which heavily influence sovereign rating levels and actions. In the most recent literature, these four variables have been identified as having a specific short-run impact on the sovereign rating. There are therefore clear links between increasing deficits, increasing debt, and lower economic growth in Europe and the downgrading of sovereign ratings.
The above literature has effectively been seeking to identify the processes within CRAs' "black box" of rating methodology. Until recently, CRAs have only been obliged to reveal vague information about their methods. They could argue that revelation of details would undermine their business advantage and potentially lead to a significant lowering of barriers to entry to the industry. However, regulatory developments following the US subprime crisis see previous section have led to increased transparency and disclosure in many elements of CRAs' activities. We find no evidence in the academic literature on the determinants of sovereign credit ratings that there is any regional or other systematic bias by the three largest CRAs.
One example see footnote 10 has reported that EU membership tends to lead to higher sovereign ratings from the three largest CRAs, all else being equal. One may consider the UK's retention of its top-ranked sovereign rating as questionable given the country's budget deficits in the aftermath of the banking crisis. However, the current UK government was well aware of the implications of a possible rating downgrade and set out a drastic austerity package which had avoiding a downgrade as one of its explicit aims.
It has so far been successful in convincing financial markets of the credibility of its austerity measures. It is argued that the UK is able to benefit from being outside the eurozone in terms of exchange rate flexibility and the expectation that economic growth will consequently be somewhat less affected by the austerity measures. However, the same is far from true in the case of sovereign ratings. Many sovereigns are rated by five or six credible agencies e. One recently quoted criticism of the industry has been that the three major agencies are USA-based.
It should be pointed out that Fitch has dual headquarters New York and London and that it is majority-owned by Fimalac SA, which is headquartered in Paris. There is also a large academic literature on split corporate ratings i. However, it is less widely recognised that split sovereign ratings are actually a frequently observed situation. It is very common for CRAs to disagree on the sovereign rating level and on the timing of rating actions. In the context of recent calls for setting up a European public-owned rating agency and for general increased competition in the rating industry, we wish to quantify the fact that the current major players in the industry have frequent differences of opinion on sovereign ratings and follow quite different rating policies.
To illustrate this, we use a sample of daily long-term foreign currency European sovereign ratings, watch and outlook for the three largest CRAs for the period from September when Fitch started using outlook for sovereigns to July Table 4 presents summary information on the rating actions. Rows 4 and 7 reveal a complete contrast between the pre-crisis and crisis periods in terms of upgrades and downgrades.
Moody's is notable in its use of upgrades of greater than one notch in the pre-crisis period. In general, it is also often the "first mover" in sovereign rating upgrades see footnote This reflects a policy difference across CRAs. Moody's ratings tend to be more stable, but can be adjusted by large amounts when the action is taken e. This Table presents summary statistics of daily long-term foreign-currency sovereign signals for European countries rated by each agency during: Rows 18 and 19 show a clear shift to rating actions on investment grade and eurozone sovereigns in the crisis period, especially for Moody's.
Rows 20 and 21 demonstrate that CRAs' outlook and watch signals have provided particularly reliable prior warning of forthcoming rating changes during the crisis period. Table 5 provides more detail on CRA differences of opinion on European sovereign ratings for the pre-crisis and crisis periods. Results are provided based on the point scale see above and also for ratings only point scale. When outlook and watchlist are considered point scale , there is clearly far greater difference of opinion split between agencies.
We believe this is the more accurate picture and hence discuss these results only. Differences between CRAs are accentuated during the crisis period. In this period, there is a strong tendency for Moody's sovereign ratings to be higher than those for the other two CRAs see Figure 3. The recent downgrades of Ireland and Portugal to speculative status by Moody's see above are very untypical of the wider sample of European sovereigns.
Figure 4 presents information on the extent of rating disagreements based on the 58 point scale. However, rating differences can be up to 20 points five notches on the point rating scale , albeit for a relatively short time. Vertical axis is the square root of the number of days for which the rating difference persists. Rating agreements are excluded from the plots. In preparing this article, we have conducted an extensive review of recent credit ratings literature; analysed the behaviour of European sovereign ratings over the last decade; studied recent publications by the ECB, IMF, Bank of England and other institutions; and considered the recent public comments made by economists, politicians and regulators.
In seeking to summarise our views, we find ourselves in broad agreement with the main conclusions and recommendations of the UK House of Lords report on sovereign ratings in July see footnote 8. We strongly encourage readers to consider this report. Specifically, we agree with the report's views that:. Are reputation concerns powerful enough to discipline rating agencies?
- Credit rating.
- Ayurveda Medical Dictionary?
- The Mark Hayes Vocal Solo Series: 7 Praise and Worship Songs for Solo Voice / Medium High.
- Wyst: Alastor 1716: Alastor 1716;
- Credit rating - Wikipedia.
- Credit Rating Agencies: Part of the Solution or Part of the Problem? | Intereconomics.
- ?
Journal of Monetary Economics, Vol. Whither the credit ratings industry? Avoiding the rating bounce: Why rating agencies are slow to react to new information, in: Journal of Economic Behavior and Organization, Vol. Sovereign credit ratings and financial markets linkages - Application to European data, European Central Bank, working paper, No.
Rating agencies' signals during the European sovereign debt crisis: Market impact and spillovers, Bangor Business School, working paper, The uses and abuses of sovereign credit ratings. IMF Global financial stability report: Sovereigns, funding, and systemic liquidity, Principles for reducing reliance on CRA ratings, Short- and long-run determinants of sovereign debt credit ratings, in: International Journal of Finance and Economics, Vol. Sovereign government rating methodology and assumptions, 30 June Leads and lags in sovereign credit ratings, in: Journal of Banking and Finance, Vol.
Over the last three years, since the financial crisis began, the volatility of financial markets has significantly increased. Such increased volatility, if it becomes a structural feature, is to be regarded as a negative phenomenon. Higher volatility is simultaneously both a signal and a catalyst of uncertainty. Growth in uncertainty worsens resource allocation. From a macroeconomic point of view, the increase in volatility is particularly important when it affects sovereign debt, for at least four reasons.
Firstly, government bonds represent a significant share of financial assets. Secondly, they are generally held by small investors, i. Thirdly, volatility in sovereign debt also tends to affect the volatility of securities issued by resident corporations and banks. Fourthly, and consequently, volatility in government bonds can more easily trigger economic policy responses, which further amplify its effects.
Lately, CRAs have actively developed their activities concerning government bonds: The empirical analysis confirms such correlation: First of all, negative rating news tends to have a negative effect, while positive news seems to have less relevant consequences.
Share this article
Hence rating news seems to affect the prices and thus yields of government debt securities. But how can the relationship between rating news and volatility be explained? Under which conditions does it have a positive or negative effect on financial markets? What are the implications for regulation? The aim of this article is to try to provide answers to these three questions by illustrating and discussing the three different explanations that economic analysis can offer regarding the relation between ratings and the volatility of government bonds.
The argument is simple: But it is possible that volatility may depend on two other sets of reasons: This would result in Excessive Volatility Risk EVR , which is damaging to markets and which it would be opportune to eliminate. The analysis will be mostly based on the literature devoted to CRAs which was developed during and after the economic and financial crisis.
The objective is to provide a better understanding of the relation between rating news and markets after the structural break represented by the crisis. The article is organised as follows: These are the two traditional ones - information view and regulatory capture view - and a new one, the communication view. The concluding section draws the implications of the analysis in terms of a prescription for regulation design. In general the activity of CRAs, as expressed through rating news, can be a driver of volatility for government bonds. But this per se is not necessarily a problem.
Ratings are by their nature procyclical. The role of ratings is to provide, through the publication of an opinion, information to markets on the likelihood that a bond-issuing agent - company, bank or government institution - may renege on its commitments. If we are dealing with new information to markets, a rating becomes relevant because it reduces information asymmetry information discovery 9 so that markets move in the same direction as the opinion expressed cliff effect 10 ; in the case of positive rating news, markets reward the issuing government, while the opposite occurs if the judgment is negative.
In addition to this, information discovery can affect future behaviour by the sovereign issuer, whose financial and economic policy choices can be either confirmed or modified according to whether the rating is positive or negative monitoring effect. In other words, if a rating offers new information to the markets, it contributes to lower macro credit risk, even if this is done at the cost of increased macro volatility risk. Any rating news conveying new information has a positive externality, since it reduces credit risk, and a negative externality, since it increases volatility risk; but the net effect is positive by definition.
The greater the degree to which rating news is relevant in terms of information discovery, the stronger the effect that that opinion will have on markets. But what does the relevance of rating news depend on? Since rating news is an output, it all depends on the inputs that go into its production function. The activities of CRAs have developed by following the principles of supply and demand. The rating news output is born from the fact that on capital markets investors need information about the agents - corporations, banks, public institutions - that issue equities and bonds.
There is a demand for information out there which rating agencies are set to meet information discovery. Ratings are supplied by private firms: If a rating fulfils the function of information discovery, thereby reducing information asymmetry on capital markets, it produces the so-called certification effect on the quality of the security and the issuer. But what does the production of information discovery, and hence the certification effect, depend on? The prime mover is the incentive for CRAs to foster a respected reputation for themselves reputation-building. As the reputation of a CRA grows, its rating news is bound to have a larger impact on the market.
There are at least three senses in which rating news offers value added in informational terms. Firstly, CRAs have access to non-public information sources data inputs. Thirdly, CRAs have the correct incentives goal function to supply a quality product, independently of the point in the business cycle or the nature of the issuer. However, recent economic analysis has questioned all three of these justifications for the information discovery produced by rating news, especially in the case of sovereign emissions.
Doubts originate from the general fact that ratings have proved ineffective on various occasions, starting with the Asian crises of and 24 ; in the case of California's Orange County default; in the Enron, WorldCom and Global Crossing cases 25 ; and in the defaults of structured finance 26 , which was identified as playing a significant role in the origin and development of the financial crisis. The ineffectiveness of rating news can have at least three different causes. First, the release of ratings on government debt, particularly if unsolicited, does not enjoy the advantage of coming from privileged information sources.
Let us list here only a sample of the hypotheses presented in this regard in the economic literature. A first hypothesis is that the economic cycle has an effect on the degree of homogeneity of ratings: CRAs tend to behave similarly during expansionary phases, while they tend to differentiate their opinions during recessionary phases of the cycle. A second hypothesis is that CRAs modify the level of severity of their assessments in a countercyclical way in order to accommodate issuers who pay for the ratings: Summing up, the information discovery regarding the reliability of sovereign government emissions that rating news should produce is far from assured.
In spite of this, we have seen that rating news continues to have important effects on market volatility. Thus, the relevance of rating news may depend on other factors. In this case, the ensuing volatility would be excessive volatility, since we would have to bear the cost of the increase in volatility risk without the benefit of the reduction in credit risk. But what does EVR depend on? The EVR of rating news can be explained starting from the fact that ratings are used as an integral part of various types of banking and financial regulation rating-based regulation. Ratings - starting with the first initiative in this field by the SEC in 35 - have been progressively embodied in numerous and significant regulations.
There are at least five areas of regulation which have seen the use of ratings: The embodiment of ratings in regulation has automatic effects on the likelihood of securities and their issuers finding a market, thus becoming a sort of quasi-public licence that affects the success of an emission licence effect. There is widespread consensus that the importance of ratings, and thus the relevance of rating news, has greatly increased since rating-based regulation was developed.
As time went by and doubts grew about the value of information discovery attributable to ratings, the hypothesis has gained ground that the relevance of a rating can itself depend on the role played by regulation no matter what the informational content. In other words, the licence effect ends up being independent of the certification effect.
Theoretically, the more likely the licence effect is, the higher EVR will be; we shall have a case in which, in the presence of inaccurate public information, there are distortions in financial markets. The economic literature has yet to explore a third channel that may explain the relation between rating news and volatility: It is surprising that this channel has been overlooked until now, in spite of the importance of communication that is intrinsic to the release of opinions by CRAs.
In other fields of economics, the analysis of the role of communication in determining the effectiveness of the transmission of information has been significantly developed - think of monetary policy or, more recently, of tasks of macro-supervision assigned to central banks. In fact, keeping the level of information discovery constant, it is intuitive and self-evident how the relevance of rating news is linked to communication policy communication effect , for various reasons.
Firstly, the importance of communication is apparent, starting with the choice of expressing the rating evaluation through letter grades, a synthetic and immediate way of communicating which is comprehensible to all investors no matter their level of financial literacy. Thirdly, the communication policy adopted is even more important in the case of evaluations of sovereign debt issuances, for the reasons illustrated in the introduction.
Fourthly, the increasingly important issue of the accountability of CRAs must be considered. But since the effect that evaluations have on markets depends not only on information but also on communication, designing mechanisms of accountability must necessarily impinge on both aspects of the policy adopted by CRAs.
Navigation menu
The crucial point is that communication policy is an integral part of information discovery. The greater the extent that rating news contains information discovery, the more the volatility caused by the communication effect will be physiological. Conversely, the more uncertain the content of information discovery, the higher the risk of EVR.
The policy of communication adopted by CRAs can be studied by highlighting at least three different aspects. First of all, the object of communication must be distinguished, which can be either a rating or an outlook. In principle, we can hypothesise that the effect on markets depends upon the type of communication - an evaluation expressed by a rating or a revision of an evaluation as formulated by an outlook.
Secondly, the modes of communication must be considered. These can take the form of a press release, a press conference or something else. Thirdly, the timing of communication must be investigated from two points of view: The activity of CRAs has effects on the volatility of yields and margins pertaining to bond emissions by sovereign governments.
If the effect on financial markets were to depend exclusively on the information discovery function contained in rating news, the negative effect would be more than offset by the positive effect in terms of more accurate information to evaluate credit risk. However, since the information discovery function of rating news cannot be taken for granted, there is a risk of excessive volatility, linked to the fact that the rating has become integrated within regulation or because of the communication policy adopted by CRAs.
From these considerations, two types of conclusions can be derived, which are linked to positive and normative analysis respectively. From the point of view of the analysis of the association between rating news and volatility, it is important to conduct empirical studies aimed at distinguishing the relative influence of the certification, licence and communication effects.
As far as regulatory implications are concerned, the resulting excessive volatility is a negative macroeconomic phenomenon. If we were to decide that the risk of excessive volatility ought to be eliminated, we would need to act on at least two fronts. On the one hand, rating-based regulation should be disposed of.
Over the last few years, there have been numerous calls at the international level to diminish the role of ratings in regulation in the medium term. Delays in this regard would make all the more robust the thesis that the intervention of regulators and politicians on ratings is slow and inadequate due to strong lobbying by the CRAs themselves, especially in the United States.
The Uses and Abuses of Sovereign Ratings, in: Global Financial Stability Review, October , pp. Boom and Bust and Sovereign Ratings, in: The Impact of Credit Rating Announcements, in: Journal of Financial Stability, Vol. News Spillovers in the Sovereign Debt Market, in: Journal of Financial Economics, forthcoming ; J. Whither the Credit Ratings Industry? Financial Stability Paper, , No. De Haan , F. Credit Rating Agencies, in: Credit Ratings and Credit Rating Agencies, in: Encyclopedia of Financial Globalization, forthcoming , Elsevier.
Credit Ratings Failures and Policy Options, in: Credit Ratings as Coordination Mechanism, in: Review of Financial Studies, Vol. De Haan et al. Rethinking Regulation of Credit Rating Agencies: The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis, in: The Role of Ratings in Structured Finance: A rating expresses the likelihood that the rated party will go into default within a given time horizon. In general, a time horizon of one year or under is considered short term, and anything above that is considered long term.
In the past institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings are commonly used. Credit ratings can address a corporation's financial instruments i. They use letter designations such as A, B, C. Higher grades are intended to represent a lower probability of default. Agencies do not attach a hard number of probability of default to each grade, preferring descriptive definitions such as: One study by Moody's [7] [8] claimed that over a "5-year time horizon" bonds it gave its highest rating Aaa to had a "cumulative default rate" of 0.
See "Default rate" in "Estimated spreads and default rates by rating grade" table to right. Over a longer period, it stated "the order is by and large, but not exactly, preserved". Another study in Journal of Finance calculated the additional interest rate or "spread" corporate bonds pay over that of "riskless" US Treasury bonds, according to the bonds' rating.
See "Basis point spread" in table to right. Different rating agencies may use variations of an alphabetical combination of lowercase and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating see colored chart. It goes as follows, from excellent to poor: The short-term ratings often map to long-term ratings though there is room for exceptions at the high or low side of each equivalent. Ratings in Europe have been under close scrutiny, particularly the highest ratings given to countries like Spain, Ireland and Italy, because they affect how much banks can borrow against sovereign debt they hold.
Best rates from excellent to poor in the following manner: From Wikipedia, the free encyclopedia. Credit Rating and the Impact on Capital Structure. Originally a bi-annual survey which monitors the political and economic stability of sovereign countries, according to ratings agencies and market experts.