Quo Vadis, Raters? A frontier approach to identify overratings and underratings in sovereign credit risk

Abstract

This study analyses overratings and underratings in sovereign credit risk. The analysis uses partial frontier methods, a technique rarely applied in this literature. By combining a robust variant of the free disposal hull (FDH) estimator, we measure both underratings and overratings for individual countries and groups of countries. Particular attention is paid to comparing pre-crisis and crisis years in order to assess possible changes in the magnitude of the deviations. Our findings indicate a remarkable degree of both overratings and underratings during the analysed period (1999-2010), which partially vanish during the last years of the sample (2008-2010)-corresponding to the financial crisis-when many downgrades took place, especially in Eurozone countries. The results allow us to emphasize the importance of monitoring these deviations for sustainable financial stability. Our results also show the potential benefits of using partial frontier methods for measuring both underratings and overratings.