By Costas Milas, Professor of Finance, University of Liverpool.
Standard & Poor’s credit rating agency said on Monday that it may downgrade the ratings of 15 euro zone countries. The warning shook the financial markets and added extra pressure to Eurozone policymakers to provide, during this week’s summit, a credible and lasting solution to the ongoing debt crisis. The warning came at a very interesting time. The European Securities and Markets Authority (an EU watchdog) is currently investigating whether credit rating decisions made by the three main credit ratings agencies (Standard & Poor’s, Moody’s and Fitch) are unjustified (see e.g. The Reuters, 6 December 2011). If wrongdoing is established, the EU watchdog could impose (heavy) sanctions.
In a recent research note published by the London School of Economics (LSE) blog at: http://blogs.lse.ac.uk/greeceatlse/2011/07/21/how-unjustified-are-the-decisions-of-credit-rating-agencies/ Prof Costas Milas (jointly with Dr Panagiotidis, Visiting Fellow at LSE) explain that in reaching their decisions, credit rating agencies cite a number of factors (such as per capita GDP, GDP growth rate, governance and public finance trends) but provide very little guidance as to the relative weights assigned to each factor. Equally important, based on well-established quantitative tests, some 40% of credit rating decisions remain unexplained.
In practical terms, this means that credit rating decisions do appear unjustified, which in turn, raises the possibility that credit rating agencies have contributed to the Eurozone debt crisis. However, statistical tests can always be contested. With this in mind, it is rather unlikely for the EU watchdog to conclude, beyond a reasonable doubt, any wrongdoing by credit rating agencies, let alone impose any sanctions. What the watchdog’s investigation can definitely do, is put pressure on credit rating agencies to increase transparency and avoid misinterpretation.
To this end, credit rating agencies will come under pressure to provide detailed guidance on the relative weights of each factor affecting their decisions.