What If Credit Rating Agencies Were Downgraded? Ratings, Sovereign Debt and Financial Market Volatility

Abstract

Abstract The activity of Credit Rating Agencies (CRAs) can lead to Excessive Volatility Risk (EVR), adversely affecting issuances of debt by sovereign governments. By EVR, we mean the risk of effects on bond yields, caused by ratings which are independent from the supply of new information ( information discovery effect ). EVR may depend on two factors: the fact that ratings are embodied into regulation ( rating ‐ based regulation effect ); the communication policies adopted by CRAs ( communication effect ). If EVR is to be reduced, on one side it is necessary to eliminate rating ‐ based regulation, and on the other to introduce forms of liability in the communication policies of CRAs. 1. Introduction Over the last three years, since the financial crisis began, the volatility of financial markets has significantly increased. Such increase in volatility, if it becomes a structural feature, is to be regarded as a negative phenomenon. Higher volatility is at the same time a signal and a catalyst of uncertainty. Growth in uncertainty worsens resource allocation. From a macroeconomic point of view, the increase in volatility is particularly important when it affects sovereign debt, for at least four reasons. Firstly, government bonds represent a relevant share of financial assets. Secondly, they are generally held by small investors, i.e. citizens/voters, so that increased volatility can translate into higher uncertainty in general expectations, with higher risk of real effects on the economy. Thirdly, volatility in sovereign debt also tends to affect the volatility of securities issued by resident corporations and banks. Fourthly, and consequently, volatility in government bonds can more easily trigger economic policy responses, which further amplify its effects. Lately, CRAs have strongly developed their activities concerning government bonds: as of July 2010, the three major CRAs were submitting their judgment 125 (Standard & Poor’s), 110 (Moody’s) and 107 (Fitch) sovereign states, respectively (IMF 2010). In general, the activity of CRAs can be a factor in contributing to the volatility of government bonds. The empirical analysis confirms such correlation: rating news regarding the publication of a rating or a revision of the opinion over an outlook by a CRA is linked to variations in government bond yields and/or spreads for associated CDS, on a number of different aspects. First of all, negative rating news tend to have a negative effect, while positive news seem to have less relevant consequences