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WorldFebruary 25 2013

Will sovereigns regulate their own ratings?

The eurozone crisis has precipitated intense scrutiny of the sovereign credit rating process, but the sovereigns themselves are hardly impartial judges.
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What’s happening?

The European Securities and Markets Authority (ESMA) announced in January 2013 that it would review the sovereign rating process this year, “prompted by concerns on the growth in volatility over the past 12 months and their importance for credit markets and financial stability”.

In the same month, the European Parliament adopted a resolution on credit rating agencies (CRAs) which contained several clauses on sovereign ratings. CRAs should publish sovereign rating updates based on a calendar announced at the start of the year, and must provide special reasoning if they deviate from it. Unsolicited ratings (where sovereigns decline to pay for the rating and may not provide full information to the agency) must be published no more than three times a year, and downgrades on multiple sovereigns must be accompanied by individual credit reports. And CRAs must “refrain from any direct or explicit policy recommendations on policies of sovereign entities” in explaining ratings actions.

What do the regulators say?

Steven Maijoor, chairman of ESMA, says there are two key reasons why ESMA has focused on sovereign ratings now. The first is to check that the agencies have the expertise and resources to cope with the greater volatility of sovereign ratings since the start of the eurozone crisis. The second is because of the potentially dangerous two-way interactions between sovereign finances and the financial system – bank bail-outs have provoked sovereign downgrades, and bank ratings depend on the expected level of sovereign support in a crisis.

“We are a risk-based regulator, so it is logical to look at the possible risks from a function where there has been increased activity and a heightened awareness of the interaction between sovereign and bank ratings, to investigate without prejudice, to see whether there is the capacity within CRAs to assess individual sovereign creditworthiness while taking into account the cross-eurozone interdependence of ratings,” says Mr Maijoor.

What do the agencies say?

The most substantial eurozone downgrades have been to Greece, Portugal and Cyprus, all of which fell below investment grade. The justifications for all those moves are clear, says Moritz Kraemer, head of Europe, Middle East and Africa sovereign ratings at Standard & Poor’s. Greece actually restructured its debt twice in 2012, and Cyprus is dependent on an uncertain EU bail-out to avoid a restructuring of its own.

“Our ratings actions remain far more measured than the activities of the market. When the market was buoyant, we were more cautious – we started downgrading Greece in 2004. And even after the rally in the second half of 2012, many eurozone periphery credit default swap spreads are still implying a much higher probability of default than our ratings,” says Mr Kraemer.

The one area where S&P has significantly modified its methodology since the crisis is on assessing the contingent liability to the sovereign from the banking sector. Previously, each banking system was placed into one of several buckets for expected gross problematic assets in a stress scenario. Now, S&P calculates individually for each sovereign the likely capital shortfall in the banking sector in a stress scenario.

RegRage-March

What do the markets say?

Investors generally support regulatory scrutiny turned on structured finance ratings, many of which proved inadequate during the financial crisis. But they are far more sceptical about the notion of sovereigns trying to clamp down on sovereign ratings that are in any case largely based on publicly available information. There is a perception that fixed calendars for ratings actions and tighter rules on multiple downgrades will restrict the ability of agencies to announce decisions in a timely fashion.

“There seems to be a strong belief among European policy-makers that if you control ratings actions during a crisis, you somehow stop the market from panicking, when in fact the opposite is true. The criticism of ratings agencies over structured finance was that their actions were not timely enough, investors want agencies to be more not less active,” says Patrick van der Wansem, founding partner of sovereign advisory firm Capitad and a former head of European public sector debt origination at JPMorgan. 

What do the multilaterals say?

All this is being carefully watched by the International Monetary Fund (IMF), which is charged with monitoring global financial stability and has contributed to eurozone bail-outs. John Kiff, a senior financial sector expert at the IMF who has published research on sovereign ratings, believes the most valuable contribution that regulators can make is to continue reducing systemic reliance on ratings.

“As long as regulators remain focused on governance, removing conflicts of interest and building the right incentives within ratings agencies, I would not be concerned about the independence of rating agencies engaged in rating sovereigns. But any attempt to regulate methodologies would be more worrying,” says Mr Kiff.

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Read more about:  Reg rage , Regulations , Western Europe