Interview with Kai Gehring: Rating Agencies, Sovereign Ratings and the Home Bias


Kehring_Kai_100Kai Gehring (Heidelberg University, photo) answers questions from Leonhardt van Efferink (GeoMeans) about the new research paper “The Home Bias in Sovereign Ratings”. Mr Gehring is PhD candidate in Economics and wrote the paper together with Dr Andreas Fuchs who works at Heidelberg university too. Below the interview, you find more information about both scholars. The paper was discussed by the Alphaville blog on the Financial Times website and got a strong response from S&P.

1. What do you mean by a ‘home bias in sovereign ratings’, and which organisations (governments, companies, banks, etc.) would benefit/suffer from it?

Many of the concerns about biased sovereign ratings revolve around the role of the credit rating agency’s “home country” – a factor largely disregarded in previous research. We define a “home bias in sovereign ratings” as a deviation of the rating level in favour of the home country, or countries that are aligned with it, from what would be justified by the respective sovereign’s economic and political fundamentals.
Such a home bias can be the result of both political economy influences and culture. Pressure can for example be exerted by the home-country government that has substantial leverage over its agencies. They control the respective regulatory body whose official recognition agencies need to operate and could thus deny that recognition.
In accordance with that, we find that on average rating agencies provide significantly better ratings to their home countries. Besides the home country itself, we also examined if banks and financial organisations as shareholders of the companies might profit from it. Indeed, we found evidence that countries in which banks from the home country hold more stakes receive on average better ratings.

2. What are the main features of the analytical framework that you used to identify home bias in sovereign ratings?

We rely on modern panel-econometric methods to evaluate the sovereign ratings of nine rating agencies from six countries, including the three big US-based agencies. In essence, we try to control for all economic and political fundamentals that should objectively explain ratings. These factors explain about 86% of the variation. Controlling for these factors, we then examine if there is a significant relationship between sovereign ratings and variables that proxy for the economic or political interest of the home country. Another example for such a variable is the cultural similarity of the sovereign to the home country.

3. How did you (implicitly) define ‘culture’ in your research and how have you measured ‘cultural similarity’ in your research?

Various previous studies have shown that cultural distance affects financial decision-making of both households and firms. Bank professionals, for example, grant smaller loans and charge higher interest rates to banks that are culturally more distant. Given this evidence, we thought it would not be surprising if cultural distance also affects decision-making at rating agencies. The conceptualization is not straightforward, but there was research by ethnologists and linguists we could build on.
We define cultural similarity in two dimensions: similarity based on ethnicity and race, and similarity based on languages. The former is more interesting when you are interested in studying discrimination, for example, if people trust other people less that look different to themselves. It builds on a biological taxonomy of species, based on genealogical relatedness.
Similarity based on languages relates more to having a similar culture, and the ease of understanding each other. We conceptualize it first with a very simple measure: If two countries have the same official language. This is obviously a rather shallow and unsatisfying measurement. Thus, we also apply another variable that measures linguistic differences based on language trees from the so-called Ethnologue project, which classifies 6,656 distinct languages into families and branches due to their linguistic origin. It also takes into account that different groups within a country exist.

4. How did you (implicitly) define ‘geopolitics’ in your research? More specifically, to what extent was it possible to fully separate the geopolitical interests of the country where the rating agency was located from its economic interests?

We use two measures. First, we use bilateral voting alignment in the UN General Assembly as a proxy for geopolitical alignment between the rated country and the home country of the rating agency. For the US agencies in our sample, we also employ a rated country’s share in US military aid as a proxy for the strategic importance that the United States assigns to these countries. When we estimate our models using both economic interest in terms of bank exposure and geopolitical alignment, it can be seen that on average geopolitical alignment is not significantly related to ratings, but bank exposure is.
The only agency for which we find a significantly positive relation to geopolitical alignment was Chinese-based Dagong. The founder of this agency entertains links to the Chinese government and the agency understands itself as a “patriotic” rating agency according to its website. The most obvious difference with regard to Dagong is that they assign higher ratings to the BRICS countries than the US-based agencies. What we find interesting, however, is that there treatment of China itself can be fully explained by their assessment of the economic and political fundamentals.

5. Where and when did you find examples of a home bias in sovereign ratings?

We find that on average, the home-country itself receives a rating about one step higher than other countries with comparable political and economic fundamentals. We also find evidence that bank exposure and cultural similarity are related to higher ratings, all else equal. The bias becomes more accentuated since the outbreak of the Global Financial Crisis, which we define as the month where Lehmann declared bankruptcy. Six of the agencies, among them Fitch, S&P and Moody’s assign higher ratings to sovereigns with the same or a similar language.
Using so-called quantile regressions we find that the cultural bias seems to be more pronounced for less stable and developing countries. Its effect is much larger for countries that are in lower rating categories. The reason could be that information from less developed countries is sparser and on average regarded as less reliable.

6. What could be the causes of the home bias that you observed?

A likely explanation can be found in the interplay between trust and incomplete information. The agencies have to rely mostly on the official data they are provided with by governments they rate. Research in Behavioural Economics and Psychology suggests that in such cases people use heuristics to account for uncertainty and a lack of information. It might be the case that, maybe unintendedly, rating agency staff assesses the information from culturally similar countries as more reliable.
This can then translate in a lower perceived likelihood that a more familiar state defaults. This is not something that is necessarily done by purpose. Everyone is more or less subject to these biases. Still, when it comes to ratings, the result may seriously affect the financing costs of countries.

7. What kind of impact do you expect your research to have? Do you expect a dialogue with and among rating agencies and other stakeholders in the rating process about your conclusions?

We believe that changes in policies and regulations should be based on thorough scientific evidence. The aim of our research was to provide such systematic empirical evidence about sovereign debt ratings. Rating agencies can play an important and potentially welfare-enhancing role by narrowing the information gap between borrowers and lenders in financial markets. However, for this to work, we need a well-functioning rating market.
We have informed all rating agencies about our results. Standard & Poor’s, for example, replied in detail with a statement that was made public on a Financial Times blog and in the German newspaper Börsen-Zeitung. While most of the points they have raised seem to be based on a misunderstanding of our methodology, we take this as positive evidence that the agencies are aware of our results and debate them internally.
With respect to the role of culture, we hope that our study is taken as a signal to improve existing methods. For instance, the newly founded agency ARC Ratings, a merger of five ratings agencies from Portugal, India, Brazil, Malaysia and South Africa, announced that every rating decision must be agreed upon by three experts from three different regions in order to ensure their objectivity. Such an approach, combined with publishing the rating committee’s voting outcomes, can both increase transparency and reduce the influence of the home country in the rating process.
However, measures need to be taken to ensure that new and smaller players can gain larger shares of the market. Regulation needs to be smart, clear-cut and simple. We know from public choice theory that over-regulation can lead to regulatory capture, and also increases the cost of market entry. Instead, the aim should be to reinforce basic economic principles and rely on enhanced competition to eliminate or at least mitigate the existing biases. Regulation can do its part by requesting ratings from several agencies from different countries. But private companies and banks can also contribute. By acquiring rating opinions from smaller players they can also encourage competition among the agencies.

Bio of Kai Gehring

Kehring_Kai_200Kai Gehring is a PhD candidate in Economics at the Chair of International and Development Politics of Prof. Dr. Axel Dreher at Heidelberg University. He is a member of the “Research Training Group: Globalization and Development” at the Universities of Hannover and Göttingen and an external lecturer at the University of Applied Sciences Kaiserlautern. His previous research focuses on the political economy of development aid, the role of economic freedom, and credit rating agencies. He has published in The Journal of Economic Behavior & Organization and World Development. His website is

Bio of Andreas Fuchs

Fuchs_AndreasDr. Andreas Fuchs is research scholar at Heidelberg University’s Alfred-Weber-Institute for Economics, where he works for the Research Center for Distributional Conflict and Globalization. During the 2012-2013 academic year, he was a postdoctoral research fellow at the Niehaus Center for Globalization and Governance at Princeton University’s Woodrow Wilson School. Andreas defended his dissertation at University of Goettingen in August 2012. His Ph.D. thesis is entitled “Political Determinants of Foreign Aid and International Trade of Emerging Economies” and has been supervised by Prof. Dr. Axel Dreher, Prof. Stephan Klasen, Ph.D. and Prof. Dr. Stefanie Walter. Andreas is affiliated with the AidData program at the College of William and Mary and Brigham Young University and has worked as a consultant for the OECD and the Bertelsmann Foundation. His research interests are in the areas of International Political Economy, Development Economics and International Trade. His website is

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