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A hard nut to crack: Regulatory failure shows how rating really works

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Abstract

Credit rating agencies such as Moody’s and Standard & Poor’s are key players in the governance of global financial markets. Given the very strong criticism the rating agencies faced in the wake of the global financial crisis 2008, how can we explain the puzzle of their survival? Market and regulatory reliance on ratings continues, despite the shift from a light-touch to a mandatory system of agency regulation and supervision. Drawing on the analysis of rating agency regulation in the US and the EU before and after the financial crisis, we argue that a pervasive, persistent and, in our view, erroneous understanding of rating has supported the never-ending story of rating agency authority. We show how treating ratings as metrics, private goods, and independent and neutral third-party opinions contributes to the ineffectiveness of rating agency regulation and supports the continuing authoritative standing of the credit rating agencies in market and regulatory practices.

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... South Africa has not been the only country whose pursuit of policy credibility has undermined its creditworthiness (see Bhogal, 2017;Datz, 2004;Grabel, 2000;Kaminsky & Schmukler, 2002;Roos, 2019). In fact, in recent years, the Big Three CRAs have received a great amount of criticism from governments, policy makers, and international financial institutions (IFIs) like the Financial Stability Board (FSB) and the IMF (see Ferri et al., 1999;IMF, 2010;Mennillo & Sinclair, 2019;Partnoy, 1999;Paudyn, 2014;Ryan, 2012). A prominent critique relates to the procyclicality of rating actions, which tends to intensify during times of crisis. ...
... These 'rating failures' have been accompanied by calls from governments and policymakers to reduce market reliance on the Big Three CRAs, strengthen supervision and regulation of the rating industry and to enhance the transparency of the rating process (Ryan, 2012;Paudyn, 2014). As a response, the US Security and Exchange Commission (SEC) has expanded its mandate to regulate CRAs, while the European Securities and Markets Authority (ESMA) has been granted centralised supervisory powers over these private firms (Mennillo & Sinclair, 2019). Yet, amidst the COVID-19 pandemic, which is expected to plunge the global economy into the deepest recession since World War II (World Bank, 2020), signs of rating procyclicality are re-emerging. ...
... This thesis aims to understand how the authority of CRAs in financial markets is constituted and the political economy of sovereign creditworthiness normalised. Building on existing literature in the field of IPE (Löwenheim, 2008;Mennillo & Sinclair, 2019;Paudyn, 2014), I show that the authority of CRAs is rooted in an epistemic culture that recognises the production of quantitative risk metrics as objective and transparent. These metrics hold out the promise of eliminating uncertainty by replacing it with risk, 'turning the incalculable to calculable and subject to rational choice modelling' ...
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Thesis
The sovereign credit ratings issued by the ‘Big Three’ credit rating agencies (CRAs) – Standard & Poor’s (S&P), Moody’s, and Fitch – significantly influence how emerging market governments structure their economies. This is despite several rating failures that have cast doubt on the accuracy and transparency of ratings and revealed problems such as conflict of interest in the business model of CRAs. Existing critiques about the political economy of sovereign credit ratings, however, fail to explain how their authority remains intact amidst these contestations. This thesis shows how the authoritative agency of CRAs and sovereign credit ratings are produced by an epistemic culture that places a high value on numerical data as a transparent reflection of reality and therefore the most rational basis for decision making. While acknowledging that ratings can be improved, the assumption is that under certain conditions, CRAs can unearth the objective ‘truth’ about a government’s fiscal profligacy. This thesis reveals the historical, discursive, and geopolitical framework that informs this assumption and how it fits into global power relationships. As such, the thesis shows how modern credit arrangements are embedded in long-term colonial histories and the continued relevance of these histories in the reproduction of the global political economy. The goal is to re-politicise the discourse of sovereign credit ratings by exposing the historical ambiguities, ideological contestations, and methodological compromises that underpin their production. This analysis is divided into two themes. The first two chapters of this project examine the historical processes through which financial markets and the economy became de-politicised, and conceived as a natural, self-regulatory mechanism that can be scientifically ‘known’ and the macro-economic policies this assumption made possible. The two chapters after that reveal the myriad subjective assessments, political considerations, and methodological compromises that go into the production of ratings. These include deciding what type of data to collect, model specifications, as well as how to interpret flawed or missing data. The final two chapters of this thesis consider how sovereign credit ratings are entangled in the political economy of South Africa. These chapters reveal the post-colonial nature of modern financial markets by showing how South Africa’s political economy has profoundly been shaped by colonial regimes of power and knowledge. Sovereign credit ratings are entangled in the reproduction of these power structures in two ways. First, the assessment of creditworthiness necessitates a forgetting of not only these violent histories and how they have come to shape asymmetrical power relations around the globe, but also their own complicity in the reproduction of these hierarchies. Secondly, their authoritative position in financial markets contributes significantly to the normalisation and sedimentation of macroeconomic policies which similarly require a ‘forgetting’ of these histories by disciplining unorthodox fiscal and monetary measures to address them. By exposing the political processes inherent in ratings, this thesis emphasises the necessity of broadening their content to enable modalities of economic policy making that aligns with the social welfare and democratic needs of society. Keywords: sovereign credit ratings, global South, South Africa, governmentality, post-colonial finance
... In particular, negative announcements have a powerful effect on the market (Afonso et al. 2011). Since markets react to changes in ratings, CRAs still represent a centralized interpretation of creditworthiness (Mennillo and Sinclair 2019) and are the gatekeepers to international capital (Kerwer 2005). However, the methods by which CRAs make their assessments are clandestine. ...
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Article
Does the political ideology of governments influence credit ratings? Previous studies report that the economic left–right dimension has an impact on credit ratings. However, recent literature shows that there are no significant differences between right-wing and left-wing debt-related policies. In addition, current political developments, such as the rise of populist movements, indicate that the economic left–right dimension may not be sufficient to describe how political ideology affects governments’ actions and thereby credit ratings. Therefore, this paper suggests that the socio-cultural dimension of political ideology or the GAL-TAN (Green–Alternative–Liberal vs. Traditionalist–Authoritarian–Nationalist) also impacts a country’s rating. In particular, the study proposes that TAN-leaning governments are perceived as a risk factor for debt repayment because they are less likely to adhere to rule of law and are reluctant to cooperate with international organizations and other domestic political parties. They also prefer protectionist policies for cultural reasons. Using data from the Chapel Hill Expert Survey for 24 European countries between 1999 and 2019, the results show that governments with TAN-leaning major parties are associated with lower sovereign credit ratings. This study contributes toward a closer understanding of what role day-to-day politics and governments’ political ideology have for the assignment of credit ratings.
... Recent literature, however, shows that their power has endured (e.g. Binici et al., 2018;Mennillo and Sinclair, 2019). This makes it even more important to investigate how these agencies interact with and affect municipal and regional governments around the world that want to access the international bond market. ...
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We investigate whether credit rating agencies are biased towards areas with strong financial centre characteristics, using data for 259 areas from 39 countries for 2004-17. We employ a range of measurements of financial centre characteristics, including a financial centre index, the share of financial and business services in an area’s total employment, and revenues from investment banking. For all financial centre proxies, our results confirm the existence of a ‘financial centre bias’ that is statistically and economically significant. For example, cities present in the global financial centre index have a rating about a category higher than would be justified by fundamentals.
Chapter
This chapter: (i) explains why private-sector Credit Rating Agencies (CRAs) and their ratings opinions are unconstitutional (with emphasis on CRAs that rate corporate, municipal and government financial-instruments); (ii) explains why government bailouts/bail-ins are motivated by Constitutional Political Economy issues, are unconstitutional and have not worked well; (iii) explains the unconstitutionality of “Obamacare” (the healthcare statutes enacted by the Obama administration in the USA), the European Union bailouts, the bailout of the US auto industry, the Nigerian banking industry and the Nigerian power industry. While US law is used in this chapter, the same legal principles are applicable in most common law countries.
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While studies show a consistent negative relationship between the level of corruption and range indicators of national-level economic performance, including sovereign credit ratings, we know less about the relationship between corruption and subnational credit ratings. This study suggests that federal transfers allow states with higher levels of corruption to retain good credit ratings, despite the negative economic implications of corruption more broadly, which also allows them to continue to borrow at low costs. Using data on corruption conviction in US states and credit ratings between 2001 and 2015, we show that corruption does not directly reduce credit ratings on average. We find, however, heterogeneous effects, in that there is a negative effect of corruption on credit ratings only in states that have a comparatively low level of fiscal dependence on federal transfers. This suggest that while less dependent states are punished by international assessors when seen as more corrupt, corruption does not affect the ratings of states with higher levels of fiscal dependence on federal revenue.
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In The New Masters of Capital, Timothy J. Sinclair examines a key aspect of the global economy-the rating agencies. In the global economy, trust is formalized in the daily operations of such firms as Moody’s and Standard & Poor’s, which continuously monitor the financial health of bond-issuers ranging from private corporations to local and national governments. Their judgments affect unimaginably large sums, approximately $30 trillion in outstanding debt issues, according to a recent Moody’s estimate. The difference between an AA and a BB rating may cost millions of dollars in interest payments or determine if a corporation or government can even issue bonds. Without bond rating agencies, there would be no standard means to compare risks in the global economy, and international investment would be problematic. Most observers assume that the agencies are neutral and scientific, and that they interpret their role in narrowly economic terms. But these agencies, by their nature, wield extraordinary power and exert massive influence over public policy. Sinclair offers a highly accessible account of these institutions, their origins, and the rating processes they use to judge creditworthiness. Illustrated with a wide range of cases, this book offers a fresh assessment of the role of an often-overlooked institution in the dynamics of modern global capitalism.
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Chapter
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Chapter
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The authority of credit rating agencies (CRAs) has been surprisingly resilient even in the face of recurrent, widely recognized and severe rating failures. This contribution analyses why rating fiascos have had little impact on CRAs’ status as transnational private authorities. This resilience is not only owing to CRAs’ own (genuinely private) sources of authority. Rather, previous public authorization of CRAs as quasi-regulators and the path-dependent politics of post-fiasco re-regulation have institutionally entrenched and legitimated their status as private authorities. Relying on a historical institutionalist approach and focusing on the regulatory setting of the European Union (EU), the article retraces how flawed public policy choices in the past, i.e., granting CRAs a recognized regulatory role, and non-intended institutional dynamics have spawned later regulatory dilemmas in dealing with CRAs’ rating fiascos. Thus, CRAs’ recent mistakes have paradoxically fostered a progressive institutionalization rather than a downgrade of their role as private governors.
Book
The financial difficulties experienced by Greece since 2009 serve as a reminder that countries (i.e., sovereigns) may default on their debt. Many observers considered the financial turmoil was behind us because major advanced countries had adopted stimulus packages to prevent banks from going bankrupt. However, there are rising doubts about the creditworthiness of several advanced countries that participated in the bailouts. In this uncertain context, it is particularly crucial to be knowledgeable about sovereign ratings. This book provides the necessary broad overview, which will be of interest to both economists and investors alike. Chapter 1 presents the main issues that are addressed in this book. Chapters 2, 3, and 4 provide the key notions to understand sovereign ratings. Chapter 2 presents an overview of sovereign rating activity since the first such ratings were assigned in 1918. Chapter 3 analyzes the meaning of sovereign ratings and the significance of rating scales; it also describes the refinement of credit rating policies and tools. Chapter 4 focuses on the sovereign rating process. Chapters 5 and 6 open the black box of sovereign ratings. Chapter 5 compares sovereign rating methodologies in the interwar years with those in the modern era. After examining how rating agencies have amended their methodologies since the 1990s, Chapter 6 scrutinizes rating disagreements between credit rating agencies (CRAs). Chapters 7 and 8 measure the performances of sovereign ratings by computing default rates and accuracy ratios: Chapter 7 looks at the interwar years and Chapter 8 at the modern era. The two chapters assess which CRA assigns the most accurate ratings during the respective periods. Chapters 9 and 10 compare the perception of sovereign risk by the CRAs and market participants. Chapter 9 focuses on the relation between JP Morgan Emerging Markets Bond Index Global spreads and emerging countries' sovereign ratings for the period 1993-2007. Chapter 10 compares the eurozone members' sovereign ratings with Credit Default Swap-Implied Ratings (CDS-IRs) during the Greek debt crisis of November 2009-May 2010. © Springer Science+Business Media, LLC 2012. All rights reserved.
Article
Short article by Dr Harry McVea (Reader in Law, University of Bristol and an IALS Visiting Fellow in 2010) providing a critical appraisal of Credit Rating Agencies (CRAs) in the light of their role in the subprime mortgage debacle and describing and assessing the EU's attempts to regulate them more strictly. Published in Amicus Curiae – Journal of the Society for Advanced Legal Studies at the Institute of Advanced Legal Studies. The Journal is produced by SALS at the IALS (Institute of Advanced Legal Studies, School of Advanced Study, University of London).
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Modern theories of rational decision-making distinguish between certainty, risk and uncertainty. When the consequences of action cannot be calculated, decision- makers confront uncertainty rather than risk. This paper examines how, as a practical accomplishment, uncertain decisions are shifted in the direction of risk, focusing on the history of credit ratings. Decision-making about credit is fraught with uncertainties, and credit rating was invented in the nineteenth century in the USA to help make those uncertainties more tractable. Credit rating methods spread widely, even before their accuracy or efficacy had been demonstrated. The origins of credit rating reveal problems and limits that reemerged during the financial crisis of 2008, when rating agencies performed very poorly. © The Author 2013. Published by Oxford University Press and the Society for the Advancement of Socio-Economics. All rights reserved.
Article
Although the meltdown in the American financial system in 2008 created the most profound financial crisis in sixty years, the field of International Political Economy (IPE) has remained curiously silent. More worrisome is the inability of the paradigmatic approach to the study of IPE in the United States – Open Economy Politics (OEP) – to shed much light on the causes of the crisis. We develop the conceptual distinction between risk and uncertainty to explain why the rationalist (and largely materialist) “American School” of IPE failed so badly. OEP followed orthodox economics in conflating risk and uncertainty. Preserving the distinction, as constructivist IPE scholars and economic sociologists have done, enables us view the crisis through dual rationalist and sociological optics. Our illustrative evidence, drawn from public (the Federal Open Market Committee of the US Federal Reserve) and private actors (accountants, credit rating agencies, and arbitrage traders) in financial markets, shows that only eclectic approaches that make use of both rationalist and sociological optics give IPE scholars the depth of vision and the breadth of imagination necessary to make sense of the financial crisis of 2008.
Book
The Independence of Credit Rating Agencies focuses on the institutional and regulatory dynamics of these agencies, asking whether their business models give them enough independence to make viable judgments without risking their own profitability. Few have closely examined the analytical methods of credit rating agencies, even though their decisions can move markets, open or close the doors to capital, and bring down governments. The 2008 financial crisis highlighted their importance and their shortcomings, especially when they misjudged the structured financial products that precipitated the collapse of Bear Stearns and other companies. This book examines the roles played by rating agencies during the financial crisis, illuminating the differences between U.S. and European rating markets, and also considers subjects such as the history of rating agencies and the roles played by smaller agencies to present a well-rounded portrait.
Chapter
Both consumer and corporate credit ratings agencies played a major role in the US subprime mortgage crisis. Equifax, Experian, and TransUnion deployed a formalized scoring system to assess individuals in mortgage origination, mortgage pools then were assessed for securitization by Moody's, S&P, and Fitch relying on expert judgment aided by formal models. What can we learn about the limits of formalization from the crisis? We discuss five problems responsible for the rating failures – reactivity, endogeneity, learning, correlated outcomes, and conflict of interest – and compare the way consumer and corporate rating agencies tackled these difficulties. We conclude with some policy lessons.
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Although China has had difficulty improving the performance of its banks and stock markets, it has struggled even more to develop a credit rating industry. Credit rating agencies (CRA), which provide bond ratings, are vital to financial markets in advanced capitalist countries, but China's credit rating companies are weak and have had little influence over the behaviour of those who issue or invest in bonds. Some argue that CRAs gain authority through their strong reputation in the eyes of market participants, but the experience of rating agencies in China supports evidence from elsewhere that their private authority is largely dependent on government mandate, a benefit China's CRAs have only recently begun to enjoy. Many private actors, from trade associations to charity groups, are struggling to gain public influence in China, but credit rating agencies may be the best barometer to measure the Chinese government's general stance towards private authority.
Article
We demonstrate that credit rating agencies aggravated the East Asian crisis. In fact, having failed to predict the emergence of the crisis, rating agencies became excessively conservative. They downgraded East Asian crisis countries more than the worsening in these countries' economic fundamentals would justify. This unduly exacerbated, for these countries, the cost of borrowing abroad and caused the supply of international capital to them to evaporate. In turn, lower than deserved ratings contributed – at least for some time – to amplify the East Asian crisis. Although this goes beyond the scope of our paper, we also propose an endogenous rationale for rating agencies to become excessively conservative after having made blatant errors in predicting the East Asian crisis. Specifically, rating agencies would have an incentive to become more conservative, so as to recover from the damage these errors caused to them and to rebuild their own reputation.
Article
Recent decades have witnessed the remarkable rise of a kind of market authority almost as centralized as the state itself - two credit rating agencies, Moody's and Standard and Poor's. These agencies derive their influence from two sources. The first is the information content of their ratings. The second is both more profound and vastly more problematic: ratings are incorporated into financial regulations in the United States and around the world. In this article we clarify the role of credit rating agencies in global capital markets, describe the host of problems that arise when their ratings are given the force of the law, and outline the alternatives to the public policy dilemmas created when ratings receive a public imprimatur. We conclude that agencies designated for regulatory purposes should be required to provide more nuanced ratings exposing their perceptual and ideological underpinnings (especially for sovereigns), and facilitating consideration of alternatives to ratings-dependent regulation.
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We find that Credit Rating Agencies (CRA)'s opinions have an impact in the cost of funding of sovereign issuers and consequently ratings are a concern for financial stability. While ratings produced by the major CRAs perform reasonably well when it comes to rank ordering default risk among sovereigns, there is evidence of rating stability failure during the recent global financial crisis. These failures suggest that ratings should incorporate the obligor's resilience to stress scenarios. The empirical evidence also supports: (i) reform initiatives to reduce the impact of CRAs' certification services; (ii) more stringent validation requirements for ratings if they are to be used in capital regulations; and (iii) more transparency with regard to the quantitative parameters used in the rating process.
Article
Both in Europe and in the United States, major steps have been taken to render credit rating agencies more accountable. But do these steps address the causes of the debacle in the subprime mortgage market that triggered the 2008-2009 crisis? Surveying the latest evidence on how and why credit ratings became inflated, this paper argues that conflicts of interest cannot be purged on a piecemeal basis. The fundamental choice is between (1) implementing a “subscriber pays” model that compels rating agencies to compete for the favor of investors, not issuers, and (2) seeking to deemphasize or eliminate the role of credit ratings to reduce the licensing power of rating agencies. Although it strongly favors the first option over the second, it also recognizes that the “public goods” nature of ratings makes it unlikely that a “subscriber pays” system will develop on its own without regulatory interventions. Thus, it considers how best to encourage the development of a modified system under which the investor would choose and the issuer/deal arranger would pay for the initial rating on structured finance transactions.
Article
This paper will explore how the financial regulatory structure propelled three credit rating agencies -- Moody's, Standard & Poor's (S&P), and Fitch -- to the center of the U.S. bond markets -- and thereby virtually guaranteed that when these rating agencies did make mistakes, these mistakes would have serious consequences for the financial sector. We begin by looking at some relevant history of the industry, including the series of events that led financial regulators to outsource their judgments to the credit rating agencies (by requiring financial institutions to use the specific bond creditworthiness information that was provided by the major rating agencies) and when the credit rating agencies shifted their business model from "investor pays" to "issuer pays." We then look at how the credit rating industry evolved and how its interaction with regulatory authorities served as a barrier to entry. We then show how these ingredients combined to contribute to the subprime mortgage debacle and associated financial crisis. Finally, we consider two possible routes for public policy with respect to the credit rating industry: One route would tighten the regulation of the rating agencies, while the other route would reduce the required centrality of the rating agencies and thereby open up the bond information process in way that has not been possible since the 1930s.
Article
Credit ratings have contributed to the current financial crisis. Proposals to regulate credit rating agencies focus on micro-prudential issues and aim at reducing conflicts of interest and increasing transparency and competition. In contrast, this paper argues that macro-prudential regulation is necessary to address the systemic risk inherent to ratings. The paper illustrates how financial markets have increasingly relied on ratings. It shows how downgrades have led to systemic market losses and increased illiquidity. The paper suggests the use of "ratings maps" and stress-tests to assess the systemic risk of ratings, and increased capital or liquidity buffers to manage such risk.
In An Engine, Not a Camera, Donald MacKenzie argues that the emergence of modern economic theories of finance affected financial markets in fundamental ways. These new, Nobel Prize-winning theories, based on elegant mathematical models of markets, were not simply external analyses but intrinsic parts of economic processes. Paraphrasing Milton Friedman, MacKenzie says that economic models are an engine of inquiry rather than a camera to reproduce empirical facts. More than that, the emergence of an authoritative theory of financial markets altered those markets fundamentally. For example, in 1970, there was almost no trading in financial derivatives such as "futures." By June of 2004, derivatives contracts totaling $273 trillion were outstanding worldwide. MacKenzie suggests that this growth could never have happened without the development of theories that gave derivatives legitimacy and explained their complexities. MacKenzie examines the role played by finance theory in the two most serious crises to hit the world's financial markets in recent years: the stock market crash of 1987 and the market turmoil that engulfed the hedge fund Long-Term Capital Management in 1998. He also looks at finance theory that is somewhat beyond the mainstream—chaos theorist Benoit Mandelbrot's model of "wild" randomness. MacKenzie's pioneering work in the social studies of finance will interest anyone who wants to understand how America’s financial markets have grown into their current form.
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