Do Country Ties of Credit Rating Agencies Matter in the Sovereign Rating Process?

Do Country Ties of Credit Rating Agencies Matter in the Sovereign Rating Process?

Worse ratings by U.S. rating agencies for European sovereigns no argument for European rating agency

The predominant Credit Rating Agencies (CRAs) Moody’s Investor Services (Moody’s), Standard and Poor’s (S&P), and Fitch Ratings (Fitch) have been criticized by leading European politicians for taking an anti-European perspective during the European sovereign debt crisis. At the same time, politicians floated the idea of launching an independent European credit rating agency. In this column, we present evidence that such an agency is unlikely to change the risk perception of investors.
Do country ties of credit rating agencies matter in the sovereign rating process? As to whether geographical and cultural distance can influence a CRA’s rating decision, the academic literature offers no clear picture. Several studies examine the relationship, coming up with contradictory results. (e.g., Ferri et al. 1999, Ammer and Packer 2000, Bartels and Weder di Mauro 2013, Gupta and Metz 2014, Fuchs and Gehring 2015).
This column reports on recent research (Altdörfer et al., 2016) examining the rating behavior of the predominant credit rating agencies, Moody’s, S&P and Fitch depending on their geographical and cultural distance to the issuer. Building on our findings that Fitch, the rating agency among the “Big Three” with significantly stronger ties to Europe compared to its two fully US tied peers, assigned on average more favourable ratings to Eurozone issuers during the crisis, we use Fitch as a role model for the idea to launch a globally active European domiciled CRA to challenge the Anglo-Saxon dominance in the rating market (The Financial Times, 2010).
How rating decisions might be affected by country ties
The academic literature provides various studies indicating that economic decisions can be affected by geographical and cultural distance (e.g., French and Poterba 1991, Chan et al. 2005, Degryse and Ongena 2005).
Political pressure can be one driver for observing differences in published ratings among the “Big Three” as stronger European ties can make a company more exposed to regulatory and political risk in Europe. Recent cases such as S&P accusing the US government of retaliation for downgrading America’s debt in 2011 as well as an SEC investigation on the American rating agency Egan Jones after the downgrade of US government bonds may suggest a sign of government retaliation to negative rating actions.
Familiarity can be another reason why stronger ties to Europe lead to a different opinion regarding the creditworthiness of a Eurozone country. For example, Wang et al. (2011) conduct a survey on risk perceptions for investment products and show that investors perceive the financial products they are more familiar with as less risky. Therefore, rating agencies who are more familiar with certain issuers may be more likely to assign better ratings.
By using the European sovereign debt crisis as a natural laboratory, we exploit institutional differences among the “Big Three” that translate into heterogeneous ties to Europe.
Institutional Background
While all of the “Big Three” rating agencies’ US presence reaches back to the very beginning of their business operations, the three share neither the same historical background nor do they have the same group structure.
Fitch stands out, as it possesses two links during the crisis that make it not only a more European company, but also a less Anglo-Saxon one compared to its two main rivals. Whereas Moody’s and S&P both maintain their headquarters in New York City, Fitch is a company with two headquarters in New York City and in London following the merger of Fitch with IBCA Limited, a British CRA, in 1997. Further, Moody’s and S&P’s group structure consists of almost exclusively US based parent companies or major equity holders. Fitch on the other hand has a key shareholder, Fimalac, which is a French holding company listed in Paris.
Our Data
We use a dataset that contains the complete rating history of all foreign currency long term rated sovereigns of the “Big Three” along with outlook and watchlist information. In addition, our dataset contains daily 10-year government bond yield data and a set of macroeconomic control variables.
The approach taken in the paper allows for a unique identification of rating differences that can only be explained by the heterogeneous ties to Europe by running a highly saturated regression that allows to control for any time series change within countries that can influence any change in a country’s credit risk, for any unobserved time variant rating differences that apply to all rated sovereigns simultaneously, and for any CRA specific ties to a given country.
Further, we run a Leader-Follower analysis as we want to find out who among the “Big Three” agencies is more likely to initiate a cycle of rating changes for Eurozone countries and who rather acts as a rating follower. Finally, we compare Moody’s, S&P’s and Fitch’s relative impact on the bond market to address the idea of establishing a European rating agency.
The main findings
Our main findings can be summarized as follows:
• Fitch, the rating agency with significantly closer ties to Europe than its two more US tied peers, holds a more optimistic view towards the creditworthiness of Eurozone issuers during and in the aftermath of the sovereign debt crisis that translates into a rating difference of on average between 0.25 and 0.59 rating notches more favourable than its two fully US domiciled peers, Moody’s and S&P.
• The differences are stronger and robust if we restrict our sample to the GIIPS countries indicating that those countries are the main driver of the observed rating difference and when we adjust the ratings for outlook and watchlist information.
• The observed rating difference is the result of a lagging behavior by Fitch as the agency acts mainly as a rating follower, while Moody’s and S&P are usually the rating agencies that initiate a sequence of downgrades for Eurozone countries.
• The on average more favourable ratings of Fitch had no significant influence on the market’s perception of the creditworthiness of Eurozone countries as investors rather follow the more conservative ratings of S&P and Moody’s
Conclusion
Country ties seem to matter in the rating process as Fitch, the rating agency among the “Big Three” with significantly stronger ties to Europe compared to its two more US tied peers, assigned on average more favourable ratings to Eurozone issuers during the crisis. However, as investors rather follow the rating actions of Moody’s and S&P, we thus doubt the often proposed need for an independent European credit rating agency.

References
Altdörfer, M., de las Salas Vega, C. A., Guettler, A., Löffler, G., 2016. European versus Anglo-Saxon Credit View: Evidence from the Eurozone Sovereign Debt Crisis. IWH Discussion Papers No. 34/2016.
Ammer, J., Packer, F., 2000. How Consistent are Credit Ratings? A Geographic and Sectoral Analysis of Default Risk. Journal of Fixed Income 668, 24-30.
Bartels, B., Weder di Mauro, B., 2013. A Rating Agency for Europe – A Good Idea? CEPR Discussion Paper Series, no 9512.
Chan, K., Covrig, V., Ng, L., 2005. What Determines the Domestic Bias and Foreign Bias? Evidence from Mutual Fund Equity. Journal of Finance 60, 1495-1534.
Degryse, H., Ongena, S., 2005. Distance, Lending Relationships, and Competition. Journal of Finance 60, 231-266.
Ferri, G., Liu, L.-G., Stiglitz, J. E., 1999. The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis. Economic Notes by Banca Monte dei Paschi di Sienna SpA 28, 335-355.
Fimalac, 2015. FIMALAC: Completion of the Sale of 30% of Fitch Group to Hearst. http://www.fimalac.com/regulated-information.html.
French, K. R., Poterba, J. M., 1991. Investor Diversification and International Equity Markets. American Economic Review 81, 222-226.
Fuchs, A., Gehring K., 2015. The Home Bias in Sovereign Ratings. Journal of the European Economic Association, forthcoming.
Gaillard, N., 2014. How and Why Credit Rating Agencies Missed the Eurozone Debt Crisis. Capital Markets Law Journal 9, 121-136.
Gupta, V., Metz, A., 2014. Measuring the Consistency of Moody’s Corporate and Public Finance Credit Ratings Across Regions. Moody’s Investors Services Special Comment.
The Financial Times, 2010. Barnier Considers EU Rating Agency. http://www.ft.com/cms/s/0/51029238-578b-11df-b010-0144feab49a.html#axzz4IQxHmEwg.
Wang, M., Keller, C., Siegrist, M., 2011. The Less You Know, the More You Are Afraid of – A Survey on Risk Perceptions of Investment Products. Journal of Behavioral Finance 12, 9-19.
White, L. J., 2010. The Credit Rating Agencies. Journal of Economic Perspectives 24, 211-226.