Rating sovereign entities is too serious a matter to be left to private credit rating agencies. Their repeated blunders and an abiding belief in a certain development model has generated a debate on the need for creating alternative structures.

The controversy focuses on the capability of private credit rating agencies to evaluate sovereign finances, given their well-known and extensively documented rating missteps in the private sector.

The most glaring example was providing AAA ratings to flawed mortgage-backed securities, thereby deliberately suppressing inherent risks from the investing public. This was one of the factors behind the financial crisis that has gripped the global economy since 2008. The Financial Crisis Inquiry Commission inferred in its final report: “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction.”

Consequently, there was an uproar followed by demands for regulating rating agencies, including from multilateral bodies like G20. A framework has been created by the International Organisation of Securities Commission, and while it does focus regulatory attention on some of the contentious issues — such as lack of adequate internal controls or inherent conflict of interest — it fails to comprehensively reform credit rating as a financial service that can capably rate sovereign finances.

Problematic methodology

There are myriad drawbacks in allowing the current crop of CRAs to continue rating creditworthiness of nations.The first problem is with the methodology. There has been criticism that the process is driven by purely balance-sheet considerations, without taking into account many unquantifiable factors that make sovereigns unique social or political organisations.

However, even if we were to accept the argument that rating exercises have a specific objective of assessing a sovereign’s creditworthiness and ability to repay commercial loans, the methodology for assessing political risks would still raise questions. For instance, Standard & Poor’s (S&P) methodology for assessing political risks accords highest marks to the following criteria: proactive policymaking, with a strong track record in managing past economic and financial crises and delivering economic growth; ability and willingness to implement reforms to ensure sustainable public finances over the long term; and high likelihood that institutions and policies will remain stable over time, ensuring the predictability of responses to future crises

A closer look shows how some of these issues can result in subjective outcomes. Take another criterion which gets countries the second-best rating: “Weaker ability to implement reforms, due to a slow or complex decision-making process.”

There are two undefined terms here. What does S&P mean by “reforms”? And, does parliamentary democracy — in which debate and dissent are two essential components — qualify as a “slow or complex decision-making process”?

S&P admits that the process is qualitative, and considers reports from the World Bank, the International Monetary Fund and the United Nations. Given the global opprobrium reserved for the worldview of these institutions, some of that censure is now rubbing off even on the three CRAs.There is another compelling reason for thinking beyond the current crop of CRAs. They are all owned by private corporations, which are listed on the stock exchanges and are subject to pressures from boards and shareholder groups. For instance, S&P is owned by McGraw Hill, Moody’s Corporation is listed on the New York Stock Exchange, and Fitch is owned jointly by Hearst Corporation — a diversified media, entertainment and real estate group — and Fimalac, a French real estate and entertainment company. It is also significant that all the three companies are located in New York.

Companies are vulnerable

This makes these listed companies also vulnerable to pressure from political forces, as well as amenable to ideological currents dominating the narrative in the US at any given point of time. Sample the pressure that was brought to bear on S&P when they downgraded US from AAA to AA+ in 2011. Eventually, S&P admitted it had erred, restored the US’s ratings and replaced CEO Deven Sharma who, ironically, had been brought in to purge the agency of its pre-crisis ills.

Here’s another example: S&P’s recent downgrading of France for not implementing “reforms” invited criticism from New York Times columnist Paul Krugman for allowing political considerations to colour its judgment. The other obvious concern is conflict of interest, especially between the parent organisation and the CRA.

Another well-acknowledged source of conflict is inherent in the “issuer-pays” model. The US senate’s report on the financial crisis is unequivocal about the conflict: “The result is a system that creates strong incentives for the rating agencies to inflate their ratings to attract business, and for the issuers and arrangers of the securities to engage in ‘ratings shopping’ to obtain the highest ratings for their financial products. The conflict of interest inherent in an issuer-pay setup is clear: rating agencies are incentivised to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business.”

The solution could be to create a completely new structure for sovereign ratings. While existing CRAs could continue to rate private sector paper within the expanded and reinforced regulatory framework, sovereign ratings need a new house. Many alternative solutions have come up. One is to bring private CRAs under public control. Former diplomat Jaimini Bhagwati has also suggested that the Indian government launch a public sector CRA.

Sensitive structure

However, such a structure would also be susceptible to fault-finding, especially when rating paper issued by government companies. Another suggestion is that BRICS nations launch their own rating agency, which would be sensitive to the unique political, socio-economic and development models of emerging nations. But this is, at best, a regional rating agency and would not be acceptable universally.

The only solution is to make an independent multilateral institution, such as the Multilateral Investment Guarantee Agency, the world's sole sovereign rating agency. MIGA would, of course, have to be unmoored from its current World Bank ties (especially in the selection of its CEO) and relocated to a site which is neither in the US nor Europe, because location eventually does have an influence on ideology.

The writer is a senior geo-economics fellow, Gateway House

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