TWN Info Service on Finance and Development (Mar21/02)
6 March 2021
Third World Network

Credit rating agencies need fundamental reform, says UN expert
Published in SUNS #9299 dated 5 March 2021

Geneva, 4 Mar (Kanaga Raja) – Reform of credit rating agencies must be part of the reform of the global financial architecture, and that these agencies should play a gatekeeper role for debt crisis prevention instead of contributing to the debt crisis, according to a UN human rights expert.

This is one of the main conclusions highlighted by Ms Yuefen Li, the Independent Expert on the effects of foreign debt and other related international financial obligations of States on the full enjoyment of all human rights, in a report presented to the UN Human Rights Council on 3 March.

“The gravity of the sovereign debt situation, exacerbated by the COVID-19 pandemic, has once again proved the need to regulate and reform credit rating agencies, which should be taken as part of the reform of the international financial architecture and debt crisis prevention and resolution,” said Ms Li.

The Human Rights Council is currently holding its 46th regular session, which concludes on 23 March.

In presenting her report to the Council on 3 March, Ms Li said that the COVID-19 pandemic has triggered multiple social, economic and human rights crises affecting millions of people.

“Debt levels, especially for public and external debt, have been rising fast, above all for developing countries, undermining the pandemic response and reversing poverty reduction and development progress,” she added.

More than 50 per cent of low-income and least developed countries are assessed at high risk of /or already in debt distress, while five developing countries defaulted on their sovereign debt in 2020.

“If the international community does not take comprehensive, effective and immediate steps to provide substantial debt relief and financial support, many developing countries on the verge of default would sink. And with them, their most vulnerable population,” said the Independent Expert.

Ms Li said that for decades, credit rating agencies have had an enormous influence on lending decisions of public and private investors and on market sentiments. In other words, they have a decisive impact on borrowing conditions and interest rates of sovereign and private debts as well as on access to international capital market.

“This is not news. In fact, past financial and debt crises, in particular the sub-prime mortgage crisis and the Asian financial crisis have exposed the inherent structural problems of these agencies and their failure to perform the role they are supposed to.”

Many reform proposals have been put forward over the years. Unfortunately, not much progress has been made so far on those reforms, she added.

Ms Li said that in her view, at the present juncture, the reforms can no longer be postponed, particularly to prevent further regression on economic, social and cultural rights because of their unfettered activities.

Noting that credit rating agencies have been called “the fire alarm that never rings,” Ms Li said instead of warning of the coming of the crisis, they end up contributing to the crisis.

“A more effective, human rights-based international financial architecture is required now more than ever in order to respond to the socioeconomic downfall resulting from the global pandemic,” she added.

In her thematic report (A/HRC/46/29) focusing on the role of credit rating agencies, Ms Li said that despite various proposals having been made over recent decades, the structural defects of credit rating agencies, the market distortions they create and the errors in their assessments have yet to be amended. The amelioration of credit ratings has been marginal, she added.

Ms Li noted that the “big three” credit rating agencies, namely, Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, continue to dominate over 92 per cent of the market and there is still no meaningful competition within this oligopolistic credit rating system.

“Accountability and transparency have not improved much. Current existing regulations have not fundamentally altered the market structure for credit rating agencies, including the massive conflict of interest,” she said.

“Many good proposals have either remained on paper or have been stalled or shelved. Yet the importance of credit rating has not diminished, as demonstrated by the difficulties encountered in the implementation of the Debt Service Suspension Initiative,” Ms Li added.

INFLUENCE OF CREDIT RATING AGENCIES

According to the report by the Independent Expert, credit rating agencies have an enormous influence on market expectations and the lending decisions of public and private investors.

However, past financial and debt crises, in particular the sub-prime mortgage crisis, have exposed the inherent structural problems of credit rating agencies and their failure to perform the role they are supposed to, Ms Li said.

“Even though many reform proposals have been put forward in recent decades, especially since the global financial crisis, not much progress has been made owing to resistance from these agencies and a lack of political will of States and regulators.”

As part of international efforts to respond to the impact of the COVID-19 pandemic, some international initiatives have been introduced to address the mounting debt burden of vulnerable countries, including the endeavour to reduce the debt service burden of poor countries so as to allow them to use their limited financial resources to save lives and livelihoods.

However, said Ms Li, the fear of possible credit rating downgrades has deterred the implementation of the Debt Service Suspension Initiative of the Group of 20. Some sovereign downgrades have also increased financial market volatility and the difficulty of these countries to gain access to new sources of financing.

“The debt situation is going to be even more challenging in 2021 than it was in 2020, when most countries suffered negative gross domestic product (GDP) growth, exploding fiscal deficits, rising unemployment and rocketing debt levels,” she cautioned.

Developing countries, in particular low-income countries, are at greater risk of defaulting on their sovereign debt and over 50 per cent of low-income countries are assessed to be at high risk of or in debt distress, according to the joint International Monetary Fund-World Bank Debt Sustainability Framework for Low-Income Countries.

There are currently unprecedented possibilities of several defaults taking place in parallel. Meanwhile, countries’ ability to use fiscal and monetary expansionary tools has become much more constrained.

“Increasing levels of private debt have been a challenging problem for developing countries, including low-income countries, for some years already. During a health and economic crisis, the possibility of this kind of debt turning into a contingent liability would increase, adding a debt burden to sovereigns,” said the Independent Expert.

“The COVID-19 pandemic has once again reminded the international community of the urgent and critical need to reform credit rating agencies in order to reduce the possibilities of a debt crisis,” said Ms Li.

She added that implementing structural reforms to credit rating agencies, as an element of the international debt architecture, would also contribute to mitigating the negative social and economic impact of these crises, which can lead to reversals of social and economic progress almost overnight, bringing immense suffering to a vast part of the population of a country.

Debt crises often affect most people living in poverty, especially women, indigenous peoples and informal workers, as well as small enterprises and small-scale farmers, adding millions of people to the ranks of the unemployed.

“A social fabric already weakened by the pandemic, with widening income and gender inequalities, is bound to suffer considerably from an added debt crisis,” said the Independent Expert.

She said that the reform of credit rating agencies should be part of the reform of the global financial architecture, adding that credit rating agencies should play a gatekeeper role for debt crisis prevention instead of contributing to the debt crisis.

“A more effective human-based international financial architecture is required now more than ever in order to respond to the socioeconomic downfall resulting from the global pandemic.”

Ms Li said in a time of profound urgency to address debt crises and to ensure the investment of limited financial resources in the realization of the human rights of millions of people in despair, it is essential to address the need for accountability, transparency and regulation of these agencies.

According to the Independent Expert, far from abating, the COVID-19 pandemic has intensified in 2021 with a rapid resurgence of cases in some countries and, worse still, with new and more contagious virus strains. As a result, many countries around the world have reintroduced lockdowns and travel restrictions.

With extraordinary fiscal and monetary expansionary policies having been adopted by central banks and fiscal authorities worldwide, 2020 did not see a systemic debt crisis even though some countries went through debt defaults and debt restructuring primarily due to pre-pandemic debt problems and the knock-on effects of the pandemic, said the Independent Expert.

“As the end of the pandemic seems to become more remote than expected and as the synchronized global economic recession persists, concerns are rising about how to keep a systemic world debt crisis at bay.”

Ms Li said that the fiscal and monetary ammunition of countries suffering from a high debt burden seems to be mercilessly insufficient.

According to the International Monetary Fund, advanced economies deployed the equivalent of 20 per cent of GDP on pandemic response, and low-income countries only 2 per cent of GDP.

“With negative GDP growth, fast-shrinking government revenue, the drastic contraction of international trade and foreign direct investment, the sudden stop of tourism and the free fall of remittances, it is natural that the debt indicators of developing countries have been deteriorating,” said Ms Li.

According to the latest data, the total external debt stocks of low-income countries eligible for the Debt Service Suspension Initiative rose 9 per cent in 2019 to $744 billion, equivalent on average to one third of their combined gross national income.

Lending from private creditors was the fastest-growing component of the external debt of Debt Service Suspension Initiative-eligible borrowers, up fivefold since 2010.

Obligations to private creditors totalled $102 billion at the end of 2019. The debt stock of the Debt Service Suspension Initiative-eligible countries to official bilateral creditors, composed mostly of the Group of 20 countries, reached $178 billion in 2019 and accounted for 27 per cent of the long-term debt stock of low-income countries.

Countries with an unprecedented high debt burden prior to the pandemic are facing even more unsustainable debt and may face insolvency sooner or later, said the Independent Expert.

“These would not be only low-income countries; many emerging economies, small island countries and middle- income countries are also facing a significant risk of unsustainable debt.”

The pandemic has exacerbated existing debt vulnerabilities in many countries, said Ms Li, explaining that it is difficult to raise new money from any source during the pandemic.

“Meanwhile, their revenue is declining and the expenditure to sustain social and economic order in their countries has been increasing quickly.”

Ms Li asked that if there is a wall of sovereign defaults, and taking into consideration a debt landscape much more complex than before with different forms of debt instruments and diverse and multiple creditors, what kind of role would credit rating agencies play?

“Would they once again hand out rapid-fire downgrades, plunging countries into even worse economic and social chaos? Would they continue to deter international efforts to assist countries in debt trouble?”

The United Nations and international financial institutions have called for urgent reforms of the international debt architecture, she noted.

The reform of credit rating agencies has not been clearly identified in an article by the International Monetary Fund calling for the reform of the debt architecture; however, this reform is long overdue, said Ms Li.

Credit rating agencies play a crucial role in the international financial system. They are supposed to act as a bridge between lenders and borrowers by reducing the information asymmetry through the provision of objective, independent and expert information on issuers or borrowers of bonds and other debt instruments and fixed-income securities.

As the purpose of lending is to receive a return on the lender’s investment, the major concern is centred around the credit worthiness of the borrower, that is, the ability of a Government or an enterprise to observe its obligations to the debt. Reliance on the information of credit rating agencies is especially heavy among institutional investors, said Ms Li.

Credit rating agencies provide analyses to evaluate the borrowers’ financial situation, as well as their political and economic conditions, based on which the agencies also would give their opinion or judgment in letter form (for example, credit ratings such as A, B, C and so forth), which varies among credit rating agencies.

Credit ratings would not only influence investors’ portfolio allocation decisions, but also the pricing of the debt instruments, such as the interest rates required for the debt to be repaid.

Therefore, credit rating agencies are market makers and movers and have significant impacts on the allocation of financial resources and the cost of the capital, said the Independent Expert.

If indeed credit rating agencies can provide expert, independent, objective and forward-looking information, they would play the role of preventing debt crises by guiding investment decisions, avoiding over-borrowing and assisting with debt crisis resolution by smoothing capital flows for countries facing temporary liquidity problems.

Their risk analysis and evaluation at country and enterprise levels, if done properly, should forewarn the coming of a debt crisis and contribute to debt crisis prevention. While debt can promote economic development if used wisely, in order to allow investors to lend their money to the borrowers who need their unused capital, credit rating agencies are needed to fill in the information gap.

“The main issue at hand is that credit rating agencies are not structured to be in a position to take a balanced and objective view of the borrower’s financial situation and its capacity to service or repay the debt,” said Ms Li.

She noted that as the sub-prime mortgage crisis of 2007-2009 erupted, and in its aftermath, many scholars and institutions expressed the view that credit rating agencies had contributed to the sub-prime mortgage crisis in the United States of America, the subsequent global financial crisis of 2007 and the escalation of the euro-zone debt crises.

These crises brought negative impacts on the economic and social situations in relevant countries, discredited the rating agencies for what was identified as their role in the crises and shed light on the inherent defects of credit rating agencies.

“The operations of credit rating agencies have long been suffering from multiple problems and failures, including the characteristics of an oligopoly; conflicts of interest; procyclicality in rating; inaccuracy or errors in their statements, rating warnings and downgrades; a lack of transparency; and accountability,” said Ms Li.

She said while the credit rating is a big international business, the credit rating market is highly monopolized by three agencies, namely Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, which also have a cross holding of shares among them, forming an oligopolistic position in the market of private and public debt.

Although there are some smaller credit rating agencies in the world, according to a report of the Securities and Exchange Commission from January 2020, the “big three” control more than 94 per cent of outstanding credit ratings, with Standard & Poor’s and Fitch Ratings occupying about 82 per cent.

The three agencies are de facto private and profit-seeking companies. However, since 1975, following the introduction of new rules by the Securities and Exchange Commission, they have been recognized as “official” rating agencies and each named a nationally recognized statistical rating organization.

This status has elevated their profile and importance while giving more credibility to their judgments. In addition, this status has further strengthened and maintained the oligopoly by making market entry barriers more formidable, thus reducing the possibility for the entrance of medium and small competing companies, said Ms Li.

The lack of competition and the privileged position these agencies enjoy appear to give the “big three” too much comfort and too little incentive to strive to hand out objective judgments of sovereign and private borrowers, she added.

CONFLICT OF INTEREST

According to the Independent Expert, conflict of interest is considered as a serious problem in the financial world and offenders, when condemned in a court of law, are subject to punishment. However, there seems to be more tolerance for conflicts of interest among credit rating agencies.

“Briefly, it can be said that their business model, usually referred to as the “issuer pay” model for their credit ratings, is at the heart of the conflict of interest. To give credit rating judgments to the very clients who pay them for their assessments casts a large shadow of doubt over the ability of credit rating agencies to give objective, impartial assessments,” said Ms Li.

“It is even harder to understand or trust the levels of objectivity when credit rating agencies are partners in the design of the investment products or financial engineering instruments, such as mortgage-backed securities, that they rated before the sub-prime mortgage crisis, reaping huge profits from the instruments they themselves had rated as AAA level. Therefore, credit rating agencies have, in many cases, been paid for positive ratings.”

The conflicts of interest of credit rating agencies have been considered one of the major underlying factors of the mortgage bubble that led to the dramatic impact on the right to housing and caused the global financial crisis, which set back many economies by a decade, said Ms Li.

In 2015, Standard & Poor’s paid about $1.4 billion to settle allegations that it had boosted ratings on mortgage- backed securities in the run-up to the crisis in the United States, including in different states in the country, admitting that it had held off on downgrades for fear of losing market share. Moody’s Investors Service paid $864 million in 2017 to settle similar charges.

Ms Li noted that the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System (also referred to as the “Stiglitz Commission”) concluded that the credit rating system was one of the specific areas most urgently in need of reform. It identified as a key problem the fact that credit rating agencies were ineffective and plagued with conflicts of interest.

Conflict of interest is the major underlining reason for many failures and errors by credit rating agencies. More transparency and disclosure could facilitate better performance.

However, this defect of credit rating agencies cannot be addressed through enhanced transparency alone, and fundamental reforms of their business model are needed, she said.

“THE FIRE ALARM THAT NEVER RINGS”

According to the Independent Expert, the ratings of credit rating agencies have a tendency to be lax or overly optimistic at the top of the economic cycle and too severe at the bottom of the business cycle.

Pro-cyclical ratings could encourage over-borrowing during good times and deepen the debt crisis during a crisis by triggering market panic and the resultant capital outflows and currency depreciation, Ms Li said.

During an upswing in the economic cycle, overly optimistic credit ratings, which underestimate default risks in order to attract investors, can lead to over-borrowing, which sows the seeds for a debt crisis, she added.

Conversely, during a period of economic downturn, when countries and enterprises require money (liquidity) to service debt and bridge fiscal gaps, such as in the context of the critical need for social investment in the midst of the COVID-19 pandemic, credit watch announcements or downgrades from credit rating agencies can lead to capital outflows and a loss of access to the international capital market owing to reputation damage caused by downgrades.

A reduction of inflows and an increase of outflows of capital from public and private investors combined with an inability to borrow new money from the international capital market could turn a liquidity problem (lack of money) into an insolvency crisis (inability to service debt) because of the credit crunch, which has been happening to some countries during the COVID-19 pandemic.

“Credit rating agencies have never once acted as a fire alarm to warn about the coming of a financial or debt crisis, which they could have done through their analyses and judgments of credit worthiness of countries and enterprises,” said Ms Li.

“Some people have called them the fire alarm that never rings. Instead of preventing debt crises, credit rating agencies have contributed to the formulation of financial or debt crises, such as the global financial crisis of 2007, and increased the severity of the crisis, such as the euro-zone debt crises and the current COVID-19 pandemic.”

For the Asian financial crisis of 1997, the global financial crisis of 2007 and the euro-zone debt crises of 2009, there was evidence of overly optimistic ratings and at times completely wrong public statements and warnings, which fuelled the pre-crisis lending boom and the capital inflows and resulting asset bubbles in some cases.

Then, when the crisis set in, there were waves of fast credit downgrades, which contributed to massive capital outflows and a loss of access to capital markets by enterprises and sovereigns.

“These actions exacerbate financial market volatility, make Governments’ efforts to contain debt crises ineffective and increase human suffering.”

Pro-cyclical downgrades can trigger a self-fulfilling prophecy of debt crises, said Ms Li.

“Credit rating agencies’ downgrades and negative statements can, in most cases, shift the sentiments of the capital market towards a debtor, and sometimes the multiplier effect can be triggered overnight. The “self-fulfilling prophecy” effect would wipe out the efforts made by Governments to resolve a debt problem.”

Credit rating agencies have shown their preference for ideological beliefs in their ratings, she added.

Ms Li cited the United Nations Conference on Trade and Development (UNCTAD) as stating that: “Credit rating agencies’ assessments appear to be based on a bias against most kinds of government intervention. In addition, they often associate labour market “rigidities” with output under-performance, and a high degree of central bank independence as having a positive impact on debt sustainability. At the same time, their ratings are significantly correlated with indicators that measure the extent to which the economic environment is “business-friendly”, regardless of what impact this might have on debt dynamics.”

Ms Li said some academics have also affirmed that credit rating agencies’ methodology in sovereign ratings shows a preference for countries implementing austerity measures.

One of the reasons why credit rating agencies are not held accountable for their inaccurate or incorrect ratings on the ground is that the credit ratings of debt instruments are considered as opinions and not judgments. Downgrades and credit watch announcements are considered as opinions expressed by credit rating agencies regarding the credit worthiness of enterprises and sovereigns.

Therefore, they have been shielded from liability by the first amendment of the Constitution of the United States, ensuring “the freedom of speech”, even though this kind of speech or opinion has the power to create volatility in the financial market, including massive capital inflows and outflows for developing countries in particular.

With this accountability gap, investors and borrowers cannot be protected from mistakes made by credit rating agencies or any abuse of power by these agencies.

Recent crises have highlighted the tremendous importance of ensuring that credit rating agencies play their role properly, said the Independent Expert.

“Therefore, it is not surprising that many proposals, especially from the United States and the European Union, were made immediately after the sub-prime mortgage crisis and subsequent global financial meltdown of 2007 and the euro-zone debt crises of 2011 to address the inherent structural defects of the agencies and the lack of regulation and accountability.”

However, most of these proposals have run into various challenges and resistance, she said, adding that thus far, little progress has been made in reforming credit rating agencies and most of the reform proposals have been either stalled or shelved completely, mainly due to strong resistance from the agencies.

The reliance on the “big three” credit rating agencies will likely continue for the near future, said Ms Li.

The Independent Expert made a number of recommendations including reducing or breaking the current oligopoly of the “big three” credit rating agencies; addressing the issue of conflict of interest; introducing a system of monitoring and accountability of credit rating agencies; strengthening the incorporation and application of relevant international human rights standards and norms in the context of the activities of credit rating agencies; suspending the issuance of ratings during a crisis when there are international efforts to introduce mechanisms to deal with the crisis; and enhancing disclosure and transparency.