This week in messenger-shooting:
(Reuters) – The European Commission said on Wednesday it had some doubts and concerns about how credit rating agencies function, but said it had no comment on individual credit ratings of countries…
Because this is not at all a comment on the ratings of Greece or Portugal downgraded on Tuesday!
However, we’ve also been reflecting on the function of sovereign ratings in the eurozone recently, including ratings contagion and analogies from the 1990s Asian crisis. We thus have a suggestion.
Perhaps the Commission would also do well to have doubts and concerns about the functioning of the following:
– Basel regulations
– ECB collateral rules
– CDS contracts
– Institutional investor mandates
They all, in some way, require certain ratings thresholds on the assets they accept in bank capital or allow either as collateral or investments. Note the prevalence of banks, and regulations that should protect against risk… but seem just to shift it elsewhere. Perverse incentives, no?
Our suggestion is inspired by this freshly-released paper by IMF staff, which points out the above as causes of ‘ratings spillover’ in financial markets when sovereigns are downgraded. Here’s a key excerpt:
[S]ome rating announcements such as rating downgrades near speculative grade (e.g. Downgrade of Greece to BBB+ from A- by Fitch on December 8, 2009) have a systematic spillover effects across Euro zone countries. We find those effects not only to be statistically but also economically significant…
The sign pattern associated with outlook revisions could suggest that financial markets react in a forward looking manner and expect the identified risks for a specific country to spread over other countries. Or, the outlook revision could be perceived as revealing information relating to a common risk across European countries. Conversely, the sign pattern associated with rating changes could result from the fact that financial markets react to downgrades by fire-selling the downgraded bonds while buying other European countries’ bond[s]. This could be explained by ratings-based rules such as those in banking regulation, ECB collateral rules, “credit events” in CDS contracts or institutional investors’ investment policies.
It might be a ‘well duh!’ moment for some but a) it is nice to have IMF statistics behind it, and b) can someone tell the EU Commission?
The credit rating history covered within the paper doesn’t make it entirely comprehensive as a post mortem on the euro crisis, as it happens. The paper stops in April 2010. Forty of the 71 ratings actions studied were in fact related to sovereigns in the Baltic and Eastern Europe. That debt crisis is somewhat overshadowed now.
There are still plenty of other interesting observations in the IMF piece, however. Did you know that S&P ratings inspired the most ‘spillover’ and Fitch the least, statistically?
Thus to close with the S&P sovereign rating downgrade du jour:
Ratings On Republic Of Cyprus Lowered To ‘A-/A-2′ On Exposure To Greece; Outlook Remains Negative
Standard & Poor’s views the Cypriot financial system’s significant exposure to the Hellenic Republic as a ratings weakness for Cyprus in the context of the deterioration in the creditworthiness of the Greek government and the Greek financial sector.
“In our view, the increasing likelihood that the Greek government will restructure its debt heightens the risk that a significant portion of the Cypriot government’s large financial-sector contingent liabilities will become explicit liabilities migrating to the Cypriot government’s balance sheet,” Standard & Poor’s credit analyst Benjamin Young said…
Commiserations to Cyprus. It must be strange to be downgraded because of another sovereign entirely.
Banking spillover, eh?
Not just a ratings rules problem.
Related links:
Cypriot contagion – FT Alphaville
Risk-weighting the eurozone - FT Alphaville
Perverse incentives – Wikipedia
