APRIL 15, 2013
(NON-) PROFITING FROM BETTER SOVEREIGN RATINGS by Annette Heuser Credit rating agencies (CRAs) have joined the ranks of the scapegoats for the recent fiscal crises in Europe and the United States. Politicians and general publics on both sides of the Atlantic show increasing intolerance of these financial players. At the center of the criticism are the CRAs’ untamed powers that stand in sharp contrast to the often-questioned quality of their products. The US Department of Justice’s lawsuit against Standard & Poor’s, a wave of excessive EU regulation and official condemnation of sovereign downgrades illustrate the growing dissatisfaction. The problems of the sector are deep-rooted and well known. The oligopoly of the big three US rating agencies prevents any meaningful competition, which has led to a lack of transparency in the ratings process. That opacity and a system that allows rated entities to pay for their own ratings form the basis of doubts about the quality of ratings themselves. Lawsuits and more regulation are not what is needed to improve the system. Ratings are first and foremost highly subjective opinions that can sow disagreement. Litigation serves only to threaten the CRAs with bankruptcy. And regulation—whether that of the EU or the US’s Dodd Frank Act—may improve transparency or ownership structures, but it does not promote needed, widespread competition. The barriers to entry in this cost-intense sector are enormous. To move forward we need to “unbundle” the services that CRAs provide. Corporate and financial ratings are among the most lucrative products for the agencies. But sovereign ratings have the most global heft. They represent not only the highest asset class but also the most emotional one. The downgrades of countries such as France, Spain and, more recently, the UK are perceived as national insults. Such demotions can quickly increase borrowing costs on international capital markets. Downgrades can also create climates of uncertainty among investors.
A new form of CRA, one based on a non-profit model, would represent a completely new type of agency that would instill market and public confidence. The funding for such an agency could come from an endowment based on contributions from governments, corporate investors and foundations—those interested in eliminating the current ratings system’s shortcomings. Any potential conflict of interest could be eliminated by using a sound governance model similar to those employed by central banks. Debates on rating decisions could be open to the public, giving a better indication of the degree of certainty the agency attaches to its rating. A non-profit CRA would be superior to the for-profit incumbents primarily because debt issuers would no longer pay for ratings, thus removing an incentive to inflate them. And the endowment would make a non-profit CRA independent from its investors. The quality of ratings should also improve since a non-profit CRA, with its secure and sustainable funding, could devote more resources to researching and assessing risk. This, however, is not enough. The quality of sovereign ratings must also improve and, to accomplish this, ratings should consider a comprehensive set of qualitative indicators in addition to traditional macroeconomic data. These indicators must be forward looking and assess, for example, a government’s crisis-management capabilities and policy consistency. Cyprus provides the most recent evidence that qualitative indicators such as governance are not thoroughly evaluated. Non-profit CRAs would undoubtedly give the market the added competitive boost that it needs. With enough investor interest, non-profit CRAs could enter the market and establish themselves as credible and reliable sources for sovereign ratings. A mere fraction of the funds American and international governments, corporations and foundations spend annually for the public good would suffice. The Bertelsmann Foundation’s INCRA (international non-profit credit rating agency) proposal already provides a framework for how this could be done. CRAs should play an important role in assessing financial risk. But new players in the sector are long overdue. A joint push by the US and the EU could make this a reality.
Annette Heuser is executive director of the Washington, DC-based Bertelsmann Foundation. annette.heuser@bfna.org More information on the INCRA proposal and the six country sample ratings based on the INCRA methodology can be found at: http://www.bfna.org/category/publication-type/incra
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