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The last month of the year has witnessed several downgrades of the credit ratings of banks and sovereigns around the world. This has mostly been greeted with incomprehension and even hostility. In Europe, where the problem is currently especially acute, the downgrades have been viewed as carrying ulterior political motives because the rating agencies are American; and as unintelligent for adding fuel to the fire.

These reactions are excessive considering that in most cases the so-called ‘downgrade’ taps on trend estimations or small shifts within a (top) category. European politicians are ill-advised to thus seek to undermine the autonomy of audit institutions at a time when both autonomy and auditing have turned out to be goods in short supply.

This does not mean that rating agencies are beyond criticism. Yet criticism should be substantiated and preferably argued in a more impassive manner. One of the big problems of the present crisis is the language in which it is communicated, and that includes the media. It is this which adds fuel to fire and not the downgrade as such.

What rating agencies do is basically evaluate the ability of a borrower, whether that is a government, a bank or other entity, to ‘service’ its financial obligations to its commercial lenders. If you have ever tried to get a loan with your bank, you probably have faced a similar procedure, whereby the criteria that apply to an individual borrower are somewhat different from those that apply to enterprises, banks or states. But basically the logic is the same: if you have no securities in the form of assets and if you are not earning regularly, you have a lower standing and you either do not get a loan or have to pay higher interest rates.

The difficulty begins when the criteria or method used to combine scores are flawed in significant ways. Below are some examples of possible faults in the approach used by rating agencies. These are based on my reading of Standard and Poor’s Sovereign Government Rating Methodology and Assumptions which was revised in June 2011.

Ratings given by Standard and Poor’s represent the combined result of scores on five multi-criteria dimensions. The five dimensions are:
(a) institutional effectiveness and political risks (political score)
(b) economic structure and growth prospects (economic score)
(c) external liquidity and international investment (external score)
(d) fiscal performance and flexibility and debt burden (fiscal score)
(e) monetary flexibility (monetary score)

  • That the rating approach should place a strong emphasis on debt is reasonable given the mission of rating agencies. Nevertheless, in multi-criteria assessment it is important to avoid double-counting. What we find instead is that:
  1. debt determines the fiscal score twice (in terms of fiscal performance and in terms of debt burden proper);
  2. it is used as an adjustment factor on the political score whereby a government with weak debt payment culture is automatically downgraded to ‘6’ (the lowest score) regardless of its performance on other sub-criteria;
  3. it is used as input for determining external liquidity.
  • The economic score is theoretically put together by considering a country’s income levels, growth prospects and economic diversity. De facto it is determined by GDP per capita, adjusted according to whether the currency is judged to be under- or over-valued and whether the economic growth is above or below average.
  • Countries which are members of a monetary union are penalized both with respect to their external score and their monetary score. Even though the Standard and Poor’s auditors are right to point out that within a monetary union poor competitiveness cannot be “eased through exchange rate adjustments” and that this implies reduced monetary flexibility, the approach is, as with the economic score, rather simplified and one-way.

Several of the individual criteria and sub-criteria used by rating agencies are useful indicators and deserve to be paid attention in the framework of macro-economic analyses. Additional criteria, however, might be necessary to correctly tap on a country’s structural capacities and deficits as well as on inter-sectoral dynamics.