Downgrading the downgraders? Ratings, sovereign debt, and financial-market volatility

Donato Masciandaro 16 September 2011



Since the financial crisis began the volatility of financial markets has significantly increased. Such increase in volatility is particularly important when it comes to sovereign debt. The credit-rating agencies have strongly developed their activities concerning government bonds: as of July 2010, the three major credit-rating agencies were submitting their judgement on 125 (Standard & Poor’s), 110 (Moody’s), and 107 (Fitch) sovereign states, respectively (IMF 2010).

In general, the activity of credit-rating agencies 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 credit-rating agency is linked to variations in government bond yields and/or spreads for associated credit default swaps (CDS). But how can the relationship between ratings news and volatility be explained? Under what conditions does it have a positive or negative effect on financial markets? What are the implications for regulation?

Ratings and the information-discovery effect

In general the activity of credit-rating agencies, as expressed through ratings news, can be a driver of volatility for government bonds. But this per se is not necessarily a problem. Ratings are by their nature procyclical. The role of ratings is to provide, through the publication of an opinion, information to markets on the likelihood that a bond-issuing agent – company, bank, and government institution – may renege on its commitments (Deb et al 2011, De Haan et al 2011, Schroeter 2011).

If we are dealing with new information to markets, a rating becomes relevant because it reduces information asymmetry (ie aids information discovery, see Pagano et al 2010 and Deb et al 2011). Markets will therefore move in the same direction of the opinion expressed (the cliff effect, see Deb et al 2011). In addition to this, information discovery can affect future behaviour by the sovereign issuer, whose choices in financial and economic policy can be either confirmed or modified according to whether the rating is positive or negative (the monitoring effect, see Boot et al 2006 and De Haan et al 2011).

There are at least three reasons why ratings news offers value-added in informational terms.

  • First, credit-rating agencies have access to non-public information sources (Deb et al 2011).
  • Second, they have access to higher-quality human capital and technology to handle such data.
  • Third, credit-rating agencies have the correct incentives to supply a quality product, independently from the point in the business cycle or the nature of the issuer.

However, recent economic analysis has questioned all of the three reasons that justify the information discovery produced by ratings news, especially in the case of sovereign emissions. Doubts originate from a general fact – ratings have proved ineffective on various occasions. This starts with the Asian crises of 1997 and 1998 (Ferri and Stiglitz 1999), and moves on to the case of California’s Orange County default, as well as the Enron, WorldCom, and Global Crossing cases (Partnoy 2009a and Deb et al 2011), and continues to the defaults of structured finance (CGFS 2005), to which a relevant role is attributed in explaining the origin and development of the 2007-2009 financial crisis (PWGFM 2008, FSF 2008, Issing Committee 2009, Turner Review 2009, De Larosiere Group 2009). In spite of this, we have seen that ratings news continues to have important effects on market volatility. Thus, the relevance of ratings news may depend on other factors. In such a case, the ensuing volatility would be excessive volatility, since we would have to bear the cost of the increase in volatility risk without the benefit of the reduction in credit risk. But from what does the excess of volatility risk derive?

Ratings and the ratings-based regulation effect

The excess of volatility risk of ratings news can be explained starting from the fact that ratings are used as integral part of various types of banking and financial regulation (ratings-based regulation).

Ratings have been progressively embodied in numerous and relevant regulations. The embodiment of ratings in regulation has automatic effects on the likelihood for securities and their issuers to find a market, thus becoming a sort of quasi-public licence that affects the success of an emission (the licence effect).

There is widespread consensus that the importance of ratings, and thus the relevance of ratings news, has greatly increased since ratings-based regulation was developed (Schroeter 2011, Deb et al 2011). But if the increase in volatility risk, amplified by licence effect, were still based on information discovery, the net effect of ratings news could still be considered as a positive externality.

As time went by, and doubts grew about the value of information discovery attributable to ratings, the hypothesis that the relevance of a rating can itself depend on the role played by regulation has gained ground, no matter the informational content (Partnoy 2011).

The licence effect ends up being independent from the certification effect. In presence of a licence effect which explains the relevance of ratings news, we would have an effect on the volatility of the value of the issuance and/or issuer which is unjustified, when the information content of the rating is considered. Theoretically, the more likely the licence effect is, the higher the excess of volatility risk will be. We shall have a case in which, in the presence of inaccurate public information, there are distortions in financial markets (Pagratis 2005, Allen et al 2006). In other words ratings news would only cause an increase in volatility risk, without the information benefits that reduce credit risk; we would thus have a net negative externality.

Rating news and communication effect

In recent research, I have suggested exploring a third channel that may explain the relation between ratings news and volatility – the communication policies of credit-rating agencies (Masciandaro 2011). It is surprising that such a channel has been overlooked until now, in spite of the importance of communication that is intrinsic to the release of opinions by credit-rating agencies. In other fields of economics, the analysis of the role of communication in determining the effectiveness of the transmission of information has been significantly developed. Think of monetary policy, or more recently, of tasks of macro-supervision assigned to central banks.1 The same type of research needs to be conducted for credit-rating agencies. In fact, keeping the level of information discovery constant, it is both intuitive and self-evident how the relevance of ratings news is linked to communication policy (the communication effect), for various reasons.

  • First, the importance of communication is apparent, starting with the choice of expressing the rating evaluation through letter grades; a synthetic and immediate way of communicating, which is comprehensible to all investors, no matter what their level of financial literacy is (Schroetter 2011).
  • Second, if the economic role of credit-rating agencies is that of information intermediaries, the definition of the modalities and timing of their communication to markets is essential for the transmission of the information contained in the evaluations of credit-rating agencies to be effective.
  • Third, the policy of communication adopted is even more important in the case of evaluations of sovereign debt issuances, for the reasons we have illustrated in the introduction.
  • Fourth, the increasingly important issue of the accountability of credit-rating agencies must be considered (Deb et al 2011, Schroetter 2011, Partnoy 2009). Discussion of the accountability of credit-rating agencies has so far been limited to liabilities linked to opinions expressed by credit-rating agencies. But since the effect that evaluations cause on markets depends not only on information but also on communication, designing mechanisms of accountability must necessarily impinge on both aspects of the policy adopted by credit-rating agencies.

The communication policy is an integral part of information discovery. The more ratings news facilitates information discovery, the more the volatility caused by the communication effect will be physiological. Conversely, the more uncertain the content of information discovery is, the higher the risk of excessive volatility risk will be.

The communication policy adopted by credit-rating agencies can be studied by highlighting at least three different aspects.

  • First of all, the object of communication must be distinguished, which can be either a rating or an outlook.
  • Second, the modes of communication must be considered. These can take the form of either a press release, or of a press conference, or something else.
  • Third, the timing of communication must be investigated, from two points of view:

o       in absolute terms, by distinguishing periodical, institutional communication, which is predictable, from the ratings news that is not;

o       in relative terms, with respect to the functioning of financial markets (eg, if ratings news is communicated when markets are closed or when they are open for business).


If we decided that the risk of excessive volatility produced by ratings news should be eliminated, we would need to act on at least two fronts. On the one hand, ratings-based regulation should be disposed of. Over the last few years, the opportunity of downgrading, in the medium-term, the role of ratings in regulation has been called for at the international level.2 In this respect an authoritative view strongly endorsed eliminating from SEC regulation every prescriptive mandate that is or would be based on credit ratings, and also   the need for banking regulators to reconsider their reliance on rating decisions (Goodhart 2011). This tendency should be encouraged and accelerated. Delays in such a direction would make all the more robust the thesis according to which the intervention of regulators and politicians on ratings is slow and found wanting due to strong lobbying, especially in the US, by credit-rating agencies themselves (Partnoy 2009). On the other hand, when considering proposals for new regulation aimed at increasing the accountability and liabilities of credit-rating agencies, the issue of communication policy should be dealt with explicitly and head on.


Basel Committee on Banking Supervision (2009), “Enhancements to the Basel II Framework”, July.

Basel Committee on Banking Supervision (2010), “A Global Regulatory Framework for More Resilient Banks and Banking Systems”, December.

Boot A, T Milbourn, and A Schmeits (2006), “Credit Ratings as Coordination Mechanism, Review of Financial Studies”, 19(1):81-118.

Born B, M Ehrmann, and M Fratzscher (2011), “How Should Central Banks Deal with a Financial Stability Objective? The Evolving Role of Communication as a Policy Instrument”, in S Eijffinger and D Masciandaro (eds.), Handbook of Central Banking and Financial Regulation after the Financial Crisis, Edward Elgar, forthcoming.

Deb P, M Manning, G Murphy, A Penalver, and A Toth (2011), “Whither the Credit Ratings Industry?”, Financial Stability Paper, Bank of England, No.9.

De Haan J and F Amtenbrink (2011), “Credit Rating Agencies”, in S Eijffinger and D Masciandaro (eds.), Handbook of Central Banking and Financial Regulation after the Financial Crisis, Edward Elgar, forthcoming.

Ferri G and J Stiglitz (1999), “The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis”, Economic Notes, 29(3):335-355.

Financial Stability Forum (2008), Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, April.

Goodhart CHA (2008), “The Financial Economist’s Roundtable Statement on Reforming the Role of SROs in the Securitization Process”,, 5 December.

International Monetary Fund (2010), “The Uses and Abuses of Sovereign Ratings”, Global Financial Stability Review, October, 85-122.

Masciandaro D (2011), “What If Credit Rating Agencies were Downgraded? Ratings, Sovereign Debt and Financial Market Volatility”, Intereconomics, eview of European Economic Policy, 47(5) (forthcoming).

Pagratis S (2005), “Asset Pricing, Asymmetric Information and Rating Announcements: Does Benchmarking on Ratings Matter?”, Working Paper Series, Bank of England, No. 265.

Partnoy F (2009), “Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective”, Legal Studies Research Paper Series, University of San Diego, No. 09-14.

Schroeter UG (2011), “Credit Ratings and Credit Rating Agencies”, in G Caprio (ed.), Encyclopedia of Financial Globalisation, Elsevier.

Securities and Exchange Commission (2011), “References to Credit Ratings in Certain Investment Company Act Rules and Forms”, March.


1 For a survey see Born et al. 2011.

2 BCBS 2009 e 2010, FSB 2008, SEC 2011; for a survey, see Deb et al. 2011.



Topics:  Global governance International finance

Tags:  financial regulation, credit-rating agencies

Full Professor of Economics, and Chair in Economics of Financial Regulation, Bocconi University


CEPR Policy Research