The issue of sovereign ratings and how they are conducted must be addressed The financial crisis in 2008 served as a catalyst to bring the shortcomings of the financial sector to the attention of the broader public. One of the key institutions put under the microscope regarding their operations and results are credit rating agencies (CRAs). CRAs are service providers that specialize in the provision of credit ratings on a professional basis. Their “job description” is to inform investors about the likelihood that they will receive all principal and interest payments as scheduled for a given security. In other words, they answer the question: what is the probability of default? In particular, the sovereign ratings produced by CRAs have come under enormous attack. The last year marked the first time that the US and some European countries have been downgraded. Every sovereign downgrade has a measurable impact: an immediate increase in a country’s cost of borrowing money. On a broader basis, sovereign ratings that are relevant to contractual and regulatory provisions can have a mechanical, pro-cyclical effect, if such provisions result in the forced selling of securities. In light of these downgrades and their critical timing, the acceptance, transparency and legitimacy of sovereign ratings have been put into question. In addition, the sector is also characterized by an oligopoly, formed by the big three CRAs: Standard and Poor’s, Moody’s and Fitch Ratings.
They account together for 95 percent of the market. Due to regulation and given the highly complex, cost-intensive business model of CRAs, the barriers to entry are fairly high. Many actors, from governments to corporate players to civil society organizations, are calling for a reform of the sector. The disaffection for the credit rating agency world is widespread across key players in societies as much as it is spread around the world from the traditional industrialized countries in Europe and the US to the emerging powers in Latin America and Asia.
But national and regional solutions, such as the European Commission proposal calling for a European CRA, can’t be the answer to an international challenge.
What needs to be done The issue of sovereign risk needs to be addressed from two angles. The first is the legal and organizational setup of CRAs: Do we need alternative institutions in addition to the traditional for-profit CRAs and who is responsible for conducting the research? The second angle focuses on the quality of the provided analysis: Is the current set of indicators used by CRAs to evaluate a country’s willingness and ability to pay back its debt sufficient? Do we need more comprehensive indicators that will also increase the predictability of a country’s financial performance?
The framework for an international solution This report provides the first blueprint for an international non-profit CRA called INCRA. INCRA has the potential
to merge the changing demands and interest of investors assessing sovereign risk and the desire of governments and the broader public for more transparency, legitimacy and accountability. INCRA, a non-profit, international network of offices, would provide a new legal framework that is based on an endowment solution to guarantee sustainability and security for its long-term existence. Financially supported by a broad coalition of funders, from governments, corporate
players, NGOs, foundations and private donors, it would be an independent entity. INCRA would be based on a sound governance model that would minimize and buffer potential conflicts of interest by a Stakeholder Council, which would separate the funders from the operational business. It would have offices in Europe, the US, Latin America and Asia.
Blueprint for INCRA: An International Non-Profit Credit Rating Agency
EXECUTIVE SUMMARY
EXECUTIVE SUMMARY