Ten years' analysis of sovereign risk: noise‐rater risk, panels, and errors

Purpose – The purpose of this paper is to examine the informative power of rating agencies in the process of establishing sovereign risk, over a ten‐year period (1997‐2006). Design/methodology/approach – First, following an earlier model, the concept of noise‐rater risk is introduced. Second, four panels were carried out to identify the most significant macro factors in determination of sovereign ratings, taking into account contemporaneous and lagged variables. The dependent variable is sovereign rating issued at the end of each year. Third, three kinds of errors committed by rating agencies when altering the sovereign ratings of emerging countries are defined. Findings – Noise‐rater risk amplifies the chances of noise traders obtaining higher returns than arbitrators. The panels show that, with the exception of debt, all other factors are sample dependant, and that variables and samples leave ample space for subjective factors. Analysis of errors demonstrates that rating agencies appear to lose their focus/ modus operandi /principles in times of crisis, and that they commit more errors immediately prior and after the onset of a financial crisis. Practical implications – The paper argues for a cautious analysis of rating agency's informative power. Like any other stakeholder, rating agencies are influenced by cognitive limitations, erroneous beliefs, and the cost of acquiring and using information. Originality/value – The paper uses behavioral finance methodologies to observe rating agencies and demonstrates, from its observations of sovereign ratings, that agencies tend to fail at times of financial turmoil, i.e. when they are most needed, by abandoning their “look at the future” principle.