Regulation needed to curb favoritism between countries and credit rating agencies, new research suggests

A country’s financial health is rated more highly when its finance minister knows top executives in credit ratings agencies, new research led by Heriot-Watt University in Edinburgh suggests.

Patrycja Klusak, an expert in credit ratings agencies and Professor of Accounting and Finance at the University’s Edinburgh Business School, says there is an inherent ‘favoritism’ problem in the business model of credit ratings agencies. This builds up when the directors and executives of credit ratings agencies have ongoing or past professional connections with particular finance ministers. For example, when a ratings agency executive and finance minister worked together in the same organization, or are former colleagues.

Countries where a finance minister has these links are associated with higher ratings than countries without these professional connections, the research concludes. The upside is particularly pronounced for developing countries, which can be rated up to seven times more highly than the equivalent impact for developed countries.

The findings are based on an analysis of professional connections between finance ministers and the top executives of the three largest credit rating agencies—Fitch, Moody’s, and S&P—for 38 European countries between January 2000 and November 2017.

The research, “Politicians’ connections and sovereign credit ratings”, is published in the Journal of International Financial Markets, Institutions & Money and is co-authored by Dr. Yurtsev Uymaz, Associate Professor in Finance with Norwich Business School at University of East Anglia and Rasha Alsakka, Professor in Banking & Finance with Bangor Business School at Bangor University.

“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,” Professor Klusak explains. “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.”

The European sovereign debt crisis of 2010–12 exposed the risk of excessive national borrowing fueling a collapse in confidence that can spill over into other countries and their corporations, banks and financial assets, Professor Klusak says.

The crisis began with the collapse of Iceland’s banking system in 2008 and led to financial bailouts in Greece, Spain, Ireland, Portugal and Cyprus. “Drastic sovereign rating downgrades” in Portugal, Italy, Ireland, Greece, and Spain were key to this and “shook the stock markets,” the research notes.

European regulators scrutinized ratings agencies in the aftermath of this crisis, particularly the conflict of interest when countries pay agencies to rate them, and get a seat on ratings agency committees as a result.

This practice, known as solicited ratings, leads to higher ratings than unsolicited ratings, the research finds. Issuing higher ratings may help the ratings agency attract more business from that country, while countries in turn are safeguarding the health of their economy through higher ratings.

Professor Klusak says the research is the first to unveil how lower credit ratings for developing countries can be influenced by credit agencies using ‘soft’ information—for example, a discussion with the country about its financial prospects and management policies—in addition to hard economic or fiscal data, such as gross domestic product.

“Developing countries can be more uncertain and opaque, with less available data,” Professor Klusak explains. “So ratings agencies need to be more conservative in their analysis. But, when presented with professional connections, these nations benefit more from higher ratings than their developed counterparts.”

The research finds that, for developed countries, business ties to ratings agencies can add roughly between one to two-thirds of a notch—classification—to their ratings across S&P, Moody’s and Fitch. For developing countries, the boost is seven-, two- and four-times bigger respectively than the equivalent for developed countries.

The research has “wide-ranging implications” for regulators, governments, market participants and credit rating agencies, Professor Klusak says. During election times, voters are also more interested in news about a country’s financial health, because it “infers the quality of incumbent governments,” she adds.

The paper calls for new rules to ensure that sovereign ratings—credit ratings of countries—are objective and independent from the rating of other asset types, like corporate loans, to avoid conflicts of interest.

Working conditions for sovereign ratings teams should also be improved—because these teams face “immense pressure” to release ratings which might bring in other business from that country—for example from its corporations and financial institutions, the researchers say.

The study contributes towards the “scarce literature” investigating professional connections in the rating industry, the researchers conclude.

Professor Klusak has been researching the behavior and regulation of credit ratings agencies for more than ten years. Her work also explores climate and biodiversity loss and its effect on future credit ratings of countries.

Before joining Heriot-Watt University, Dr. Klusak was an Associate Professor in Banking and Finance with Norwich Business School at the University of East Anglia, where she has been based for eight years. Professor Klusak is also an Affiliated Researcher at the Bennett Institute for Public Policy, a public policy research institute at the University of Cambridge.