Economics 101: Ratings agencies’ reports should be taken with a grain of salt

The goal of a credit-rating agency is to plug an informational gap oin the creditworthiness of potential debtors. But just how trustworthy are they?

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Standard & Poor's on January 27 downgraded Sharjah's sovereign debt rating, meaning that the emirate will have to offer higher rates of interest to attract creditors. Credit-ratings agencies have been actively downgrading GCC sovereign debt ratings during the 2014-2016 oil price crash. How are such decisions made, and are they trustworthy?

The goal of a credit-rating agency is to plug an informational lacuna regarding the creditworthiness of potential debtors. In principle, they expend resources on gathering data that is otherwise unavailable to prospective creditors and on analysing that data in a manner that is beyond the immediate intellectual capabilities of prospective creditors; they then combine these outputs to deliver an assessment that clients take into consideration when they make lending decisions.

Unlike apples or pencils, credit-ratings reports are commodities that the consumer cannot assess the quality of at the time of purchase, or even upon consumption. This is because they discuss predictions about future rather than current events. Moreover, the complexity and instability of the world means that it is very difficult to retrospectively assign blame when predictions prove inaccurate.

This opens the door for supplier malpractice – credit-rating agencies can willfully cut corners to save money, or they may simply exhibit negligence because of the difficulty of holding them accountable. Alternatively, due to the presence of an ulterior motive (such as the risk of a loss of business from important clients), they might produce biased reports.

In principle, market competition can limit fraud as credit-rating agencies that produce low-quality or biased reports will lose customers, while the agencies that deliver accurate assessments will secure a larger share of the market. Two factors, however, impair the competition’s ability to weed out poor service delivery.

First, credit defaults, which are the primary event that credit-rating agencies are trying to predict, are quite rare events, especially at the sovereign level, meaning that it can take a long time to gather enough data to determine the quality of a specific agency. This data cycle is lengthened by the self-fulfilling tendencies of certain predictions – when an influential credit-rating agency predicts that a country will default with high likelihood, it will be forced to pay higher amounts to service its debt, making a default more likely, and making it harder to assess the quality of the original predictions.

Second, the process of producing credit-ratings exhibits “economies of scale”, meaning that the cost of producing a unit declines as the level of production rises. This is because operating at a larger scale makes it easier for agencies to acquire useful data and cheaper to analyse the data as many economic factors are common to multiple countries, such as the common legal environment faced by members of the EU, or the common effect of oil on the GCC economies.

Economies of scale often lead to higher levels of industry concentration as larger producers easily undercut smaller ones. In the case of credit ratings, three large providers – S&P, Fitch and Moody’s – dominate the market. Oligopolistic settings make it easier for companies to collude and manipulate the market at the expense of consumers, undermining the role of competition in delivering quality services.

Thus, for example, if a government wanted to pressure credit-rating agencies into delivering a certain rating, they only have to deal with three companies. In contrast, trying to influence all of the global media would be a logistical nightmare given how many thousands of providers exist.

Unsurprisingly, therefore, credible accusations of malpractice were directed toward credit-rating agencies after the 2008 global financial crisis, forcing them into corrective action. That is why one should always interpret credit reports with caution and acknowledge that the nominal independence of global agencies is no guarantee of accuracy.

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