Empirical Evidence of Bias in Sovereign Ratings

Abstract

This paper analyzes if and what kind of sovereign rating bias exists. We analyze three possible biases. Firstly, rating agencies may have the incentive to rate countries where they earn more money better compared to countries where they earn less (profit maximizing bias). Secondly, different information asymmetry levels between the rated sovereigns and the rating agencies could lead to a bias (information asymmetry bias). A third bias could be due to the fact that a rating agency applies higher ratings to a country with which the country where the rating agency is located has stronger relations (home country bias). For the analysis of a potential home country preference we use a novel approach to the existing financial literature on rating bias: in particular, we use variables proxying the interconnection between the country in which the rating agency is headquartered and the rated country. This paper finds no empirical evidence of profit maximizing bias on the level of sovereign ratings but a significant bias in sovereign ratings caused by information asymmetry. The results of the analysis of home country bias are ambiguous. The interconnection of the US with the rated country proxied by the trade channel does not imply any home country bias; nevertheless, when a different proxy -- based on the interconnection between US-financial institutions and the respective countries -- is used, at first glance the results indicate a bias with respect to the ratings from Moody's only. However, this finding turns out not to be robust.