Damned if you do, damned if you don't.
Rating agencies are in an inextricable situation when it comes to sovereign ratings. On the heels of their near-collapse of structured products, they must confront the issue of the credibility of sovereign ratings in a holistic way.
The question of the legitimacy of sovereign ratings cannot be answered by a yes or a no. There is something structurally questionable in the simple fact that rating agencies -- being private companies and sometimes part of listed groups -- appoint themselves as the ultimate judges of policies of sovereign governments.
This is a serious question. Sovereign ratings are increasingly perceived as a challenge to democracy: it confirms, in the eyes of the public, the view that Wall Street wants to exercise its supremacy on democratically elected governments in the name of "capitalism." Perception, in this case is reality.
Three aspects of sovereign ratings need to be reformed to provide the right legitimacy.
- Independent governance. Rating agencies have to organize their sovereign rating activities in a way that does not convey the impression of a black box, where decisions are made secretly, disclosure is lacking and timing is arbitrary. In order to improve the perception of objectivity, clear governance has to be set up, independent from shareholders' influence, with the right safeguards. Extreme clarity has to be conveyed, as the stakes are too high to leave sovereign ratings in the hands of management alone. A system of "sovereign rating trustees," with the majority of members being non-owners, could aid in diffusing the impression of obscure governance or lack thereof. This would also ensure the protection of diversity among rating agencies.
- Transparency is insufficient. I reviewed the justifications of recent sovereign and bank downgrading of warnings, and found them extremely questionable in their content. They generally do not include any form of analytical reporting of the situation of the country rated. The explanations are based on "events," perceptions, judgments and opinions. Considerations on the creditworthiness of the country and its ability to face the repayment of its debts are vague. This conveys the image of subjectivity rather than transparent explanation and reasoning. Such transparency might lead to arguments, but said disputes will be based on analytical elements. The brutal three-notch downgrade of Portuguese banks was not substantiated by any new elements.
- Rating changes must be timed correctly. The recent actions of rating agencies have often given the impression of a cross-agency competition, follow-up of recent market movements, which should not enter into consideration. I would propose a periodic review system where countries are reassessed on a quarterly basis, and in certain circumstances, on a monthly basis. Abrupt announcements have the appearance of journalistic sensationalism, with the sole intention of creating a surprise effect. Only the emergence of a new and substantial element can justify a "surprise." Sovereign ratings should not be a Damocles' sword hanging above the head of governments.
Reforms along those three lines would do a lot to restore an impression of objectivity, market independence, good governance, and transparency. These elements together make up the missing ingredient: trust.
Rating agencies have been the first victims of their own subjectivity, resembling actors rather than referees. Sovereign ratings do not need to be in line with market perception. On the contrary, the role of rating agencies, is to be a calm, objective voice acting as an anchor of reference on country risks.
I am not naïve. Governments are not transparent and blame the agencies to act on information or analysis that they tried to hide, or even lied upon. In some circumstances, the ultimate sanction might be for a rating agency to declare that it interrupts its rating of a specific country because governments are not transparent or providing adequate and credible information. This would be better than expressing sometimes fuzzy opinions. Like any issuer, public sector borrowers are accountable for the information they provide or hide. They, too, have a duty of transparency.
Their reactions to negative ratings are as hypocritical as their applause when they get a good note. They have the responsibility for the future of their countries and their economies. It was stunning to see Michel Barnier, the European Commissioner for the Internal Market, suggest this week that sovereign ratings should be prohibited for countries subject to a bail out. In other words, the thermometer is legal is you are in decent health: when you need serious health assistance, ignore the thermometer.
Rating agencies are not the sovereign risk department of major financial institutions. They are a provider of objective and serious analysis of those risks. It is up to the risk departments of financial institutions to translate a rating into an investment decision. As in underwriting, they must provide their independent credit analysis.
This is a time for clarity and objectivity. It is a substantial reform but would provide capital markets and investors with the right balanced input.