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The Damaging Bias of Sovereign Ratings
An eye-watering USD 50 trillion in outstanding sovereign debt is guided by sovereign credit ratings. And, since these set the benchmark for all other credit ratings, the implications of sovereign ratings extend much further.
Just three firms (Moody’s, S&P and Fitch) dominate the market. They set ratings based on a combination of measurable fundamentals (the objective component) and the judgment of their in-house ratings committees (the subjective component).
In this paper, they decompose the ratings into their objective and subjective components. We find that, whilst the objective component of ratings is a good predictor of future sovereign default, the subjective component of ratings has no predictive power on average for defaults one or more years ahead, but adds large distortions to individual ratings.
Just three firms (Moody’s, S&P and Fitch) dominate the market. They set ratings based on a combination of measurable fundamentals (the objective component) and the judgment of their in-house ratings committees (the subjective component).
In this paper, they decompose the ratings into their objective and subjective components. We find that, whilst the objective component of ratings is a good predictor of future sovereign default, the subjective component of ratings has no predictive power on average for defaults one or more years ahead, but adds large distortions to individual ratings.