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Developed Market Sovereign Bonds: 'UniCredit's analysis is flawed'

The UniCredit research paper on which its article in the current issue of IPE is based, ‘The Damaging Bias of Sovereign Ratings’, contains sweeping allegations and is based on a methodology that Standard & Poor’s (S&P) rejects. Our sovereign ratings have excellent long and short-term track records. Indeed, a 2010 IMF study on sovereign ratings found that CRAs provide a robust ranking of sovereign default risk.

UniCredit’s claims that sovereign ratings have a “damaging bias” that has “nearly turned into a self-fulfilling disaster prophecy” in the euro-zone periphery are baseless, as is their claim that rating agencies have “clearly contributed to .… untold social hardship” in countries like Italy.

The basis for their conclusions is an arbitrary algorithm, in which sovereign ratings are estimated by a simple regression analysis using 10 variables as determinants of the “objective” sovereign rating. Deviations of actual ratings from that estimate are interpreted as credit committees “overruling” fundamental signals. They claim that “there is little dispute about which variables should be included in an analysis of a country’s creditworthiness”. We dispute UniCredit’s analysis and selection of variables. 

In fact, none of the 10 variables chosen by them is referenced in our own methodology. And their claim that S&P does not disclose the variables we take into consideration is untrue. Our detailed criteria is available for free on our public website. 

UniCredit’s regression analysis is flawed. For example, it chose “advanced economy” status (as defined by the IMF) as an explanatory variable. Being an “advanced economy” (including euro-zone peripherals) raises the “objective” rating in UniCredit’s linear regression by 3.2 notches. That variable, by itself, explains virtually all of the difference between the supposedly “objective” rating and the actual ratings by S&P. 

Applying an “advanced economy” dummy variable is not only lacking any analytical justification, but it flies in the face of the observation of the recent default of two “advanced economies” in the euro area – Greece and Cyprus. 

We will continue to rigorously apply our transparent and publicly available sovereign criteria. That approach has served investors well. S&P was the first rating agency to raise concerns about brewing euro area problems when we started to lower peripheral sovereign ratings, beginning with Italy in mid-2004. This was at a time when the market continued to treat peripheral sovereign ratings on a par with German bunds. 

Our annual (and public) sovereign ratings performance statistics demonstrate that our ratings accurately rank-order sovereign default risk. This is the sole purpose of sovereign ratings. UniCredit is wrong to say that this consistent performance is “hardly a sufficient criteria for success”.

The UniCredit report suggests that credit rating agencies should be “stripped of their regulatory powers” and these “transferred to an international body”. It is the case already that an international initiative, led by the Financial Stability Board on behalf of the G20 (and being pursued in Europe through the CRA3 rating agency regulations), aims to reduce overreliance on credit ratings in the financial system. 

 We support the ending of regulatory requirements or incentives that encourage mechanistic use of ratings. Ratings should be one way – but not the only one – for assessing credit risk.

Moritz Kraemer is chief sovereign rating officer at Standard & Poor’s. Fitch Ratings was also invited to respond to the Unicredit paper but declined.

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