Reforming the Reformers: Seville Conference Must Upgrade Credit Rating Agencies

The high cost of debt and consequent debt servicing have meant that financing for environment, climate adaptation, and food security gets short shrift when there’s a debt crisis. Credit rating agencies and international regulations need to change to realize the needs of developing countries.

At the United Nations’ 4th International Conference on Financing for Development, currently taking place in Spain, the priorities of developing countries need to be up front and center. The latest outcome document for the conference underscores this. Any final agreement from the conference in Seville that ignores this call will mean that the meeting did not deliver.

A key output of the meeting should be a reform of the credit rating system. Today, Fitch Ratings Inc., Moody’s Ratings, and S&P Global Ratings are the main credit rating agencies of the world. The credit rating architecture determines the cost of capital that developing countries must pay to borrow. In 2023, many developing countries paid more than 5 percent more than the developed world for lending from official creditors.

An important component within the envisioned outcome is the establishment of the Africa Credit Rating Agency and to “fully operationalize it.” If adopted, this will finally realize the specialized and different needs and contexts of African countries in the international financial architecture. It would be good if other developing countries, including countries from Asia Pacific including India as well as Small Island Developing States and landlocked countries joined this call, to not just focus on operationalizing the recently established Africa Credit Rating Agency, but to overhaul the global credit rating architecture so that the reality of developing countries is recognized.

More than 85 percent of the global population lives in developing countries, and almost 45 percent of the world’s GDP is accounted for by emerging and developing economies. The time has come for international financial architecture to consider the needs of developing countries, as “mainstream” and not an afterthought.

Why is the credit rating architecture important? And how does it affect international lending by international financing institutions like multilateral development banks (MDBs) and development financing institutions (DFIs)?

Financial instruments deployed by MDBs and DFIs include direct debt and equity (at both market rate and below market rate terms), lines of credit to commercial banks, intermediated investments via funds (including impact funds), guarantees, and technical assistance. They also provide concessional finance, which mobilises other private investors. Today, most lending from MDBs and DFIs focuses on investments in infrastructure: 34 percent of concessional and market-rate finance provided in the Global South in 2021 (roughly $2.5 billion) focused on this sector. This compares with only 7 percent focused on the agriculture sector in the same year, and far less on climate adaptation.

However, conservative financial regulations and international financial regulations constrain investments in the Global South. Regulations such Basel III and IV (the international regulatory framework developed by the Basel Committee on Banking Supervision, first set up in 2008–2009 to respond to financial crises) and reporting requirements of the financial system such as International Financial Reporting Standard 9 and 10 (IFRS9 and IFRS 10, respectively) are biased against incorporating the realities of the developed world. These regulations and standards also affect lending from national and public development banks that are similarly deterred from investing in agriculture and climate adaptation.

These reporting systems penalize investments in rural sectors, and agricultural sectors. As a result, banks (multilateral and national banks) end up allocating their capital to less risky sectors that have, for instance, more regular payments than the seasonal nature of agriculture allows, and those that offer more predictable returns and require lower capital charges. High capital adequacy requirements also limit banks’ overall lending capacity, increasing the opportunity cost of lending to businesses that are perceived as higher risk and less profitable (e.g., smaller or less formal businesses in rural areas).

As a result of these requirements, in East African countries, Central Banks require domestic commercial banks to hold between 10 and 15 percent of their capital, well above Basel III requirements (which is 8.5 percent). This exacerbates the low levels of commercial bank lending to the agriculture sector in the region, which in 2019 averaged 6 percent despite the sector contributing roughly 60 percent to GDP.

This is not all. Now, new Basel IV regulations require banks to take a standardised approach to determining risk-weighted assets (RWAs). These disincentivise global banks from financing rural infrastructure projects in the Global South, which are perceived as being risky. Before the implementation of Basel IV began in 2023, banks could use proprietary models that considered investment history to allocate risk weightings to different assets. Now they need to use standardised capital weightings that assign higher risk weightings to investments in countries that have low national credit ratings, and to loans with longer tenors. Additionally, standardised approaches to calculating RWAs do not account for the reduced risk associated with banks—or indeed other investors—that invest in a senior tranche of a blended finance structure where a first-loss guarantee has been provided by an impact investor or DFI. This has also meant that participating in blended finance confers no additional advantage to investors, irrespective of the first risk loss being taken by another party or investor.

This skewed nature of risk appraisal also affects MDB lending, even though MDBs are not expected to adhere to the same regulations as commercial banks. MDBs target AAA credit ratings from major credit ratings agencies (e.g., S&P, Moody’s, and Fitch) to ensure they are viewed as creditworthy and can borrow at low cost. While this means that MDBs can pass on the benefit of low-cost borrowing to borrowers (including rural businesses), the reality is that MDBs end up managing their capital so they can get these credit ratings. This limits MDB’s overall capacity to take on ventures that are perceived as being risky, including those perceived for rural or agricultural investments.

A recent paper by Sachs et al. lays this out succinctly. The challenge is not the amount of capital—indeed, rural and adaptation financing requires a relatively small amount, $250–300 billion per year by 2030, respectively, which, compared to the many other gaps, is relatively small.

Developing countries are far more agricultural and rural. Lending and borrowing in these contexts should not be considered “below investment grade,” which in turn requires banks to write down the asset. Rural sectors such as agriculture and tourism are generally perceived as “high risk” due to their cyclical nature, seasonality, and exposure to external shocks. Looking at 16 African countries in 2022, the United Nations Development Programme found that the misalignment of credit ratings cost these countries $74 billion in lost investment opportunities and (higher) interest payments.

Seville must ask for a reform of the international rating architecture that causes high liquidity and key sectors in developing areas to be rated as high risk.

Jo Puri is an adjunct fellow (non-resident) with the Sustainable Development and Resilience Initiative at the Center for Strategic and International Studies in Washington, D.C.