Content area
Full text
ABSTRACT
The 2008 financial crisis has served as a catalyst for re-examining the forces of systemic financial crisis, the leading of which was perceived to be the inaccurate credit ratings. Although sovereign credit ratings constitute a small part of the credit rating industry, the impact of unexpected downgrades or upgrades has a huge potential to distort a well-functioning financial system. There appeared plenty of researches in the literature that discussed the inaccuracy of sovereign credit ratings and argued that these measurements are negative biased toward developing countries. By using ordered response models, this paper investigates whether this bias stems partially from cross country variations in the quality of institutions. Measured by six different governance indicators namely "Control of Corruption", "Voice and Accountability", "Political Stability and No Violence", "Government Effectiveness", "Regulatory Quality", and "Rule of Law", institutional quality was found to have positive impact on the rating decisions. Although the simulation of the estimation results revealed that all the governance indicators reduce prediction errors significantly, "Government Effectiveness" and "Regulatory Quality" were predominantly responsible for low sovereign credit ratings.
JEL Classifications: C51, E44, G15, G24
Keywords: Sovereign credit ratings, governance indicators, developed country, developing country
INTRODUCTION
Credit ratings and credit rating agencies (CRAs) are debated harshly in the aftermath of 2008 financial crisis. The crux of the matter was the accuracy of the credit ratings. Hard debates were not surprising, since just after the collapse of Lehman Brothers, many countries have faced rating downgrades that have pro-cyclically increased their financial vulnerabilities (see Afonso et al., 2012; Ismailescu and Kazemi, 2010). Elkhoury (2008) discusses the potential impacts of credit ratings on developing countries and calls for stricter regulation on CRAs. Although there have been significant regulatory amendments regarding the CRAs in US, UK, and EU, the accuracy of credit ratings is still open to debates.
The accuracy of sovereign credit ratings has been debated from "bias" perspective recently (Gultekin-Karakas et al. 2011 and Ozturk, forthcoming). The common conclusion is that sovereign credit ratings are biased toward developed countries and arguably not an accurate credit risk measurement. As a contribution to the current debates around credit ratings that question the bias issue, we examine differences in institutional quality between developed and developing countries that can account for wide...