The Origin of Bias in Sovereign Credit Ratings: Reconciling Agency Views with Institutional Quality

Abstract

The 2008 financial crisis has served as a catalyst for re-examining the forces of systemic financial crisis, the leading of which was perceived to be the inaccurate credit ratings. Although sovereign credit ratings constitute a small part of the credit rating industry, the impact of unexpected downgrades or upgrades has a huge potential to distort a well-functioning financial system. There appeared plenty of researches in the literature that discussed the inaccuracy of sovereign credit ratings and argued that these measurements are negative biased toward developing countries. By using ordered response models, this paper investigates whether this bias stems partially from cross country variations in the quality of institutions. Measured by six different governance indicators namely “Control of Corruption”, “Voice and Accountability”, “Political Stability and No Violence”, “Government Effectiveness”, “Regulatory Quality”, and “Rule of Law”, institutional quality was found to have positive impact on the rating decisions. Although the simulation of the estimation results revealed that all the governance indicators reduce prediction errors significantly, “Government Effectiveness” and “Regulatory Quality” were predominantly responsible for low sovereign credit ratings.