Published on 24 April 2020
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Economics  •  Regulation

First-mover disadvantage: the sovereign ratings mousetrap

Research by Patrycja Klusak (Affiliated Researcher at Bennett Institute), Moritz Kraemer (Goethe-University and former Managing Director and Chief Rating Officer at S&P Ratings Service's), and Huong Vu (Aberdeen University) finds that the credit rating agency (CRA) which is a first-mover in downgrades of sovereigns falls into a commercial trap and receives a penalty in the form of a loss of a market share

Understanding rating agencies‘ different reaction functions on sovereign ratings is insightful for ratings users such as investors. A firmer sense of which agency tends to be leading in times of changing credit quality can allow them to make better and faster decisions for themselves and their clients. But there is an additional, commercial aspect to keep in mind, which, in the absence of robust safeguards and supervision, might influence CRAs’ ratings behaviour.

Contrary to a popular belief, the vast majority of sovereign ratings of the Big Three CRAs such as S&P, Moody’s and Fitch are solicited. This means that a contract exists between rating agency and government issuer, stipulating both parties’ rights and obligations. One of the obligations of the issuer is to pay the CRA a publicly undisclosed fee, which can be a yearly surveillance fee, an issuance fee, or a combination of the two. The fact that most sovereign ratings are paid for would suggest that the sovereign business contributes positively to the bottom line of the CRAs, especially if one considers downstream business that results from the assignment of a sovereign rating. This can include state-owned companies or financial institutions amongst others. CRAs typically do not assign corporate or other ratings in a country if the corresponding sovereign is not rated first. Therefore, the commercial impact of sovereign ratings for CRAs can be much larger than the relatively small number of rated sovereigns (as compared, for example to corporates) would suggest.

This can cause a dilemma for a CRA. While being the first mover on an upgrade cycle is typically met with applause by the affected government, the reaction can be quite adverse if a government is faced with a downgrade for the first time. In some cases, the government may decide to cancel the contract with the downgrading CRA which will be observed via a drop in a market share. This has, of course, an immediate impact on the financial results of the CRA in question. Where it considers that sufficient market interest exists in a sovereign rating the CRA may choose to continue coverage in form of an unsolicited, i.e. non-fee paying, rating. Either way it loses financial income.

Although the first agency to downgrade is the most relevant to rating users it is not regarded as highly by the issuers who’s cost of capital increases as a result. The leader may take a financial hit when the sovereign issuer cancels the contract. Meanwhile the follower CRAs, who downgraded the issuer consequently after, share the cheese.

Where CRAs have been sued for issuing “wrong” ratings in other asset classes than sovereigns it has usually been for not downgrading bonds fast enough, i.e. analysts answered judicial questions why the rating was “too high”. Sovereign analysts appear to have to responded to the opposite accusation, having to justify why the rating was allegedly “too low”. Considering the prominence of sovereign ratings in the political debate sovereign analysts can come under immense pressure. In order to uphold the integrity and relevance of the sovereign ratings process every effort must be made to protect analysts from those potential non-analytical influences.

Our paper suggests that the first-mover in downgrades receives a penalty observed via reduction of a relative market share. This issue points to the need that special attention may need to be given in protecting sovereign analytical staff’s analytical independence.

Analysts must remain effectively shielded from commercial corporate interests of the CRA itself through robust, transparent and uncompromising compliance rules separating analytics from the business. Analysts must also feel secure in the understanding that by expressing their analytical opinions and vote accordingly in credit committees, they will not in any indirect way impact their own career or employment prospects at their firm. It falls with the purview of regulators to monitor the strict and unerring adherence to the latter and the spirit of effective compliance arrangements and investigate to what extend organisational or staffing changes at CRAs might be an expression of a conflict of interest within the CRA.

The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.


Patrycja Klusak

Dr Patrycja Klusak

Affiliated Researcher

Dr Patrycja Klusak is an Associate Professor at Norwich Business School at University of East Anglia and an Affiliated Researcher at Bennett Institute for Public Policy at the University of...

Dr Moritz Kraemer

Dr Moritz Kraemer is an international economist and expert in credit analysis and economic policy. Moritz is Chief Economic Advisor of Acreditus, a UAE-based risk consultancy firm, and Independent Non-Executive...

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