Recently, Fitch, Moody's Investors Service, and Standard & Poor's announced several changes or clarifications to their ratings policies in regards to the sovereign ceiling and bank ratings. In June 2001, both Moody's and Fitch, and on July 23, Standard & Poor's, clarified their policies towards the sovereign ceiling.[i] While some of these changes apply to ratings generally, our concern in this comment is particularly with the impact they have on bank ratings.
But before exploring the significance of these changes, or clarifications as the case may be, it is helpful to take a broader look at the meaning of ratings and the rationale for the earlier policies. Ratings, of course, are evaluations of relative risk, distilled into a single symbol. They resemble a school grade in this respect, but unlike school marks, their purpose is not the evaluation of past performance — although this they take into account — but the estimate of the probability of future default and the loss in such case. The sovereign ceiling refers to a traditional view by rating agencies that the risk of default reflected in the sovereign debt rating of a particular country should be an upper limit, that is, a ceiling, on the debt ratings of other entities headquartered in the same jurisdiction.
The concept derives from the notion that as the sovereign exercises regulatory control over such entities, their risk of default is subject to the exigencies of the government. For example, in a foreign currency crisis, a government may impose a moratorium on a foreign exchange remittances, as the Philippine government did in the mid-1980s, compelling otherwise creditworthy issuers to default. As Fitch, then known as Fitch-IBCA, explained the concept in a 1998 report:
A sovereign's rating on its foreign currency obligations has traditionally been regarded as a ceiling on ratings for other issuers domiciled in the country. The operative assumptions are that a sovereign default could force all other domestic issuers to default or that a sovereign could force other issuers to default as a means of avoiding its own default. Circumstances leading to a national foreign exchange crisis -- including economic and political upheavals, balance of payments crises, trade shocks, and high inflation -- directly affect the debt servicing capacity of private borrowers. Countries facing default may impose exchange controls and other restrictive measures that impede access by issuers to the foreign currency necessary to service their obligations.[ii]
Other rating agencies have traditionally maintained similar guidelines, applied more or less rigidly depending upon circumstances. The 1998 Fitch report noted that sovereign default did not always result in the default in the private sector. To take one example, it noted that in some circumstances, for example, Venezuela in the mid-1990s, a defaulting sovereign would encourage private borrowers to continue debt service. The agency's policy, therefore, would be flexible, depending upon a variety of criteria.
As in any rating exercise, the issuer's standalone financial strength and business prospects were of paramount concern. Corollary considerations included access to foreign currency earnings and diversification of revenue streams. Local debt ratings were more apt to exceed the sovereign ceiling than foreign currency ratings, since payments in local currency have little effect on a nation's foreign reserves, and hence it is much less likely a government would restrict such payments. Finally, the track record of the issuer and the sovereign, the existence of external support relationships, such as a strong multinational parent, and government policy were key concerns to Fitch as to whether the sovereign ceiling should be pierced.
Moody'sand Standard & Poor's historically have applied the sovereign ceiling concept in practice fairly strictly. Exceptions have long been recognized, however, in the case of securitizations where techniques such as the creation of offshore special purpose vehicles, guarantees, insurance and over-collateralization and other 'credit enhancements' enabled its circumvention. These exceptions, however, proved the rule in that use of an offshore entity as a conduit for funds flows or external support mechanisms kept the credit enhanced issuer or debt out from under the operation of the sovereign ceiling rule.
Moody'spolicy statement[iii] this year does represent a significant step away from exacting application of the sovereign ceiling. The agency said its decision was based on recent experience in several countries where "governments in default may choose to allow foreign currency payments on some favored classes of obligors or obligations". Moody's went on to note that while the sovereign ceiling would apply in most cases, it would not be rigidly applied. Criteria to be considered in piercing the sovereign ceiling were: First, standalone creditworthiness and external support; second, the likelihood of the applicable government refraining from the imposition of a general payment moratorium; and third, the borrower's access to foreign currency.
S&P's clarification, issued this week, implicitly acknowledges the applicability of the concept commonly referred to as the sovereign ceiling, but favours factoring sovereign risk into issuer and debt ratings according to the circumstances.
While [the] relationship [between the sovereign risk and the risk associated with locally domiciled issuers and debt] varies by type of entity, when a sovereign is either in distress or in default economic and financial market conditions are, in general, most likely quite hostile for all issuers in the given country. Therefore, there is typically a link between an issuer's ratings and those of the relevant sovereign.
Like Moody's, S&P observes that empirical data supports the proposition that a sovereign default usually, but not always, results in private entity default. The exceptions are significant enough — both agencies indicate that in about one third of the cases, a sovereign default does not trigger a private entity default — so that a rigid rule is not appropriate. Cases where a private entity rating may be higher than the sovereign rating, according to S&P, tend to fall into one of the following categories (excluding credit enhancements):
