Standards are poor: The revealed expertise of a leading credit rating agency
When credit rating agencies make mistakes, these mistakes are bound to have serious consequences for the financial sector and for the economy and society at large. This is virtually guaranteed by the financial regulatory structure, but it is also due to and enhanced by the reliance of financial investors on the competence of rating agencies.
‘Mistakes’ may come as random errors or of biases. They may result from conflicts of interest and the incentive structure within which rating agencies operate, or reflect a lack of expertise. In the first categories, some studies claim that ratings contain an ideological bias against financial titles issued by governmental entities (see, e.g., Cornaggia, Cornaggia and Hund (2012)), or suffer from a cultural bias favouring Anglo-Saxon or English speaking countries (see, e.g., Fuchs and Gehring (2013)). Regarding the rating agencies’ expertise, however, there is little evidence beyond Gaillard’s finding (2012) that there is an astonishing lack of macroeconomics majors in the sovereign ratings teams of the big three agencies.
Following this lead, this paper takes a closer look at the market for government bonds, in which credit rating agencies have established themselves as key players, and the expertise that has spawned the recently exploding outflow of sovereign ratings. Point of departure is the empirical analysis provided and the questions asked in Gärtner and Griesbach (2012). Their paper sketches a quantitative picture of the market for government bonds which points to the possibility of multiple equilibria and the risk of self-fulfilling prophecy. Then market psychology in general and sovereign debt ratings in particular may generate the very conditions they are predicting, even if these were to lack a fundamental basis.
Standard & Poor’s (see Kraemer, 2012) has commented on this paper under the unequivocally disapproving title “S&P's Ratings Are Not ‘Self-Fulfilling Prophecies’ “. This comment’s line of argument offers a rare opportunity to gauge the professional competence that is behind the flurry of sovereign downgrades which kept Europe’s politicians busy for four years running. The current paper takes Standard & Poor’s arguments serious, dissecting it step by step. The sobering result is that the world’s leading credit rating agency appears to possess a very limited understanding of the market for government bonds, suffers from an ignorance of key features of its own procedures, and has a rather limited potential to engage in logical discourse.