Rating the Law: How Financial Rating Agencies are Assessing the Legal Risks of Financial Transactions

Abstract:     
Financial rating agencies are key actors of financial markets. Their different ratings are usually pre-conditions for issuing securities or bonds. If they assess the financial viability of the financial instruments issued, they also assess the soundness of the legal arrangements used. Thus, taking the law into account is a key element of their assessment. At a macro level, their ratings may express an opinion of the economic attractiveness of a territory. The same may apply to the legal framework used by issuers. Surprisingly, the literature on this topic reveals to be scarce. This paper aims at fulfilling this gap.

It studies, in particular thanks to interviews, how rating agencies consider the law while rating a country, an enterprise or a financial structured instrument. One of the hypotheses we wanted to test was whether financial rating agencies use synthetic indicators of law and institutions effectiveness such as those of IFC (World Bank Group) Doing Business annual reports and if there are biases for or against certain legal traditions. Firstly, this study assesses the relatively informal methodology used by the rating agencies to assess the quality of the legal framework of instruments issued on markets. Secondly, the study reveals in particular the existence of several biases: a general prejudice against Case law and a specific bias in favour of Common Law jurisdiction. This study reveals that, on average, due to the limitations of the ranking used by rating agencies, all other things being equal, corporations or bonds issued from countries unduly ranked should suffer from this prejudice. The paper tries to quantify the sensitivity of rating models to the assessment of the quality of the legal environment. Finally, this paper considers what regulation framework would help to cope with the exhibited drawbacks and to improve the fairness and the effectiveness of the rating process.

Number of Pages in PDF File: 21

Keywords: Financial rating agencies

JEL Classification: G10, G28, K22

working papers series