Abstract
The financial crises of 2008 and 2010–11 have led regulators to seek ways to reduce mechanistic reliance on rating agencies: rating actions, and in particular sovereign downgrades, heavily affect the financial system—especially banks—and the real economy, also due to the existence of a ‘sovereign ceiling’ for domestic issuers. We analyse first the channels by which sovereign downgrades have an impact on sovereigns themselves, on banks and other financial institutions, on non-financial firms and, ultimately, on the real economy. After explaining why the Eurosystem needs credit ratings for monetary policy implementation and describing the way ratings are ‘hardwired’ in the Eurosystem’s and other major central banks’ collateral frameworks—most of the financial risks borne by the Eurosystem’s balance sheet arise from assets assessed by rating agencies—we provide an overview of the recent academic and policy debate, in particular of those authors who encourage the Eurosystem to end the use of agencies’ sovereign ratings and rely instead on the assessment of sovereign risk developed internally or provided by another European public institution. In the last section, we examine the extent to which the Eurosystem has so far reduced its reliance on rating agencies.
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Notes
- 1.
The investment grade label is assigned to issuers with a rating at least equal to BBB−. The sub-investment grade label refers to issuers with a rating below BBB−.
- 2.
This outcome is more likely for bilateral transactions than for centrally cleared transactions.
- 3.
The other two sources (see Sect. 3.1) are national central banks’ In-House Credit Assessment Systems (ICASs) and counterparties’ Internal Ratings-Based (IRB) systems.
- 4.
- 5.
See e.g. IMF (2010).
- 6.
Afonso et al. (2012) analyse credit events involving 24 EU countries between 1995 and 2010.
- 7.
The previous downgrades to junk by Standard & Poor’s and FitchRatings (on 24 November 2017 and 18 December 2019) had not been sufficient to exclude the country from this important index.
- 8.
- 9.
On the one hand, domestic sovereign exposures keep enjoying a favorable prudential treatment, having zero risk-weights. On the other hand, the rules on leverage ratios and—in Europe—the supervisory exercises have tightened the prudential treatment of sovereign exposures (see Lanotte et al. 2016). Furthermore, banks might want to avoid the substantial mark-to-market losses that would emerge in case of a pronounced increase in bond yields (see, Fig. 1.17.3 in International Monetary Fund 2019).
- 10.
Foreign investors tend to be more reactive to news and change their holdings more rapidly than domestic investors.
- 11.
Sovereign ratings normally act as a ceiling for the ratings to corporate borrowers. Arezki et al. (2011) and Correa et al. (2014) find out a positive correlation between changes in sovereign ratings (especially downgrades) and bank stock prices. Adelino and Ferreira (2016) show that rating agencies downgrade intermediaries operating in countries where the sovereign has been downgraded and do so irrespectively of banks’ health.
- 12.
- 13.
- 14.
See Sushko and Turner (2018): they estimated the share at 20% in 2018 but, given the significant increase of passive investment in recent years, at the end of 2020 the level was probably higher. Financial Times (2022) quoted a report by JP Morgan according to which in the United States, between end 2019 and end 2022, the share of passive funds has increased from 23 to 29% of total managed funds.
- 15.
See ESRB (2020a).
- 16.
According to Aramonte and Eren (2019), in the case of corporate bonds, active managers could sell up to one third of their holdings in case of downgrade below investment grade.
- 17.
Due to the technological developments that affected markets microstructure in recent years, this impact could be exacerbated by algorithmic and high frequency players (widely known as “momentum players”); their speculative, directional activity could amplify the degree of the movement, leading to so called “flash crash” events. See BIS (2016, 2018).
- 18.
The European regulatory framework (EMIR) sets out minimum requirements for what concerns collateral eligibility criteria and, more generally, for margins, which primarily depend on the historical volatility observed on the market for each financial instruments. These requirements must be fulfilled by CCPs’ internal models, which normally take into account a large number of indicators in addition to external credit ratings.
- 19.
The ISDA Master Agreement include references to ‘credit events’ and ‘credit downgrade’ by a rating agency. Furthermore, the parties can indicate ‘additional termination events’, which often include the downgrade of an entity’s credit rating. The eligibility criteria of the securities posted as collateral in repo transactions are listed in the Global Master Repurchase Agreement, and subject to additional constraints related to counterparties risk management practices. In bilateral markets, these agreements typically contain a Credit Support Annex that clearly specifies type, credit quality, and applicable haircuts for all eligible collateral.
- 20.
The study uses a large sample of 80 countries between 1990 and 2013, thus capturing inter alia the rating dynamics observed during the European sovereign debt crisis.
- 21.
The Eurosystem accepts only most senior tranches of ABSs that have at least two ‘single A’ ratings and are backed by a homogeneous and publicly reported pool of assets.
- 22.
Additional Credit Claims are those bank loans that do not fulfil the ordinary framework’s eligibility requirements but satisfy the wider criteria set by each national central bank, which bears the related financial risks.
- 23.
See “Guidelines on Eligible Collateral” of Bank of Japan.
- 24.
- 25.
Such classification refers to short-term ratings.
- 26.
See “Collateral management in central bank balance policy operations” of Bank of England.
- 27.
- 28.
The Facility ceased purchasing eligible assets on 31 December 2020.
- 29.
See “Terms and Condition for RIX and monetary policy instruments” of Sveriges Riksbank.
- 30.
See Muller and Bourque (2017).
- 31.
In a similar vein, Vernazza and Nielsen (2015) suggest that credit rating agencies should be stripped of their regulatory powers for sovereign ratings.
- 32.
This view has been expressed by the same author also in a more recent paper (Orphanides 2020); according to the author, the ECB should draw on the success of the temporary measures adopted in April 2020 in response to the pandemic and eliminate cliff effects in its collateral framework on a permanent basis, by ceasing the delegation of the determination of collateral eligibility of government debt to private credit rating agencies. In the same vein, see also Lengwiler and Orphanides (2021).
- 33.
See FSB (2010).
- 34.
See FSB (2014).
- 35.
See the Eurosystem reply to the European Commission’s public consultation on credit rating agencies of February 2011.
- 36.
See the ECB’s Public Guideline on ECAF rules.
- 37.
See ECB (2015).
- 38.
- 39.
See ECB (2022).
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Alessandri, P. et al. (2023). The Role of Rating Agencies: Implications for the Financial System and Central Banks’ Efforts to Reduce their Reliance. In: Scalia, A. (eds) Financial Risk Management and Climate Change Risk. Contributions to Finance and Accounting. Springer, Cham. https://doi.org/10.1007/978-3-031-33882-3_6
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