Almost two years ago, I was driving in my car in Germany, and I turned on the radio. Europe at the time was in the middle of the Euro crisis, and all the headlines were about European countries getting downgraded by rating agencies in the United States. I listened and thought to myself, "What are these rating agencies, and why is everybody so upset about their work?"
Well, if you were sitting next to me in the car that day and would have told me that I would devote the next years to trying to reform them, obviously I would have called you crazy. But guess what's really crazy: the way these rating agencies are run. And I would like to explain to you not only why it's time to change this, but also how we can do it.
So let me tell you a little bit about what rating agencies really do. As you would read a car magazine before purchasing a new car or taking a look at a product review before deciding which kind of tablet or phone to get, investors are reading ratings before they decide in which kind of product they are investing their money. A rating can range from a so-called AAA, which means it's a top-performing product, and it can go down to the level of the so-called BBB-, which means it's a fairly risky investment. Rating agencies are rating companies. They are rating banks. They are rating even financial products like the infamous mortgage-backed securities. But they can also rate countries, and these ratings are called sovereign ratings, and I would like to focus in particular on these sovereign ratings.
And I can tell, as you're listening to me right now, you're thinking, so why should I really care about this, right? Be honest. Well, ratings affect you. They affect all of us. If a rating agency rates a country, it basically assesses and evaluates a country's debt and the ability and willingness of a country to repay its debt. So if a country gets downgraded by a rating agency, the country has to pay more in order to borrow money on the international markets. So it affects you as a citizen and as a taxpayer, because you and your fellow countrymen have to pony up more in order to borrow. But what if a country can't afford to pay more because it's maybe too expensive? Well, then the country has less available for other services, like roads, schools, healthcare. And this is the reason why you should care, because sovereign ratings affect everyone. And that is the reason why I believe they should be defined as public goods. They should be transparent, accessible, and available to everyone at no cost.
But here's the situation: the rating agency market is dominated by three players and three players only — Standard & Poor's, Moody's, and Fitch — and we know whenever there is a market concentration, there is really no competition. There is no incentive to improve the quality of your product. And let's face it, the credit rating agencies have contributed, putting the global economy on the brink, and yet they have to change the way they operate.
The second point, would you really buy a car just based on the advice of the dealer? Obviously not, right? That would be irresponsible. But that's actually what's going on in the rating agency sector every single day. The customers of these rating agencies, like countries or companies, they are paying for their own ratings, and obviously this is creating a conflict of interest.
The third point is, the rating agencies are not really telling us how they are coming up with their ratings, but in this day and age, you can't even sell a candy bar without listing everything that's inside. But for ratings, a crucial element of our economy, we really do not know what all the different ingredients are. We are allowing the rating agencies to be intransparent about their work, and we need to change this.
I think there is no doubt that the sector needs a complete overhaul, not just a trimming at the margins. I think it's time for a bold move. I think it's time to upgrade the system. And this is why we at the Bertelsmann Foundation have invested a lot of time and effort thinking about an alternative for the sector. And we have developed the first model for a nonprofit rating agency for sovereign risk, and we call it by its acronym, INCRA.
INCRA would make a difference to the current system by adding another nonprofit player to the mix. It would be based on a nonprofit model that would be based on a sustainable endowment. The endowment would create income that would allow us to run the operation, to run the rating agency, and it would also allow us to make our ratings publicly available. But this is not enough to make a difference, right? INCRA would also be based on a very, very clear governance structure that would avoid any conflict of interest, and it would include many stakeholders from society. INCRA would not only be a European or an American rating agency, it would be a truly international one, in which, in particular, the emerging economies would have an equal interest, voice and representation.
The second big difference that INCRA would make is that would it base its sovereign risk assessment on a broader set of indicators. Think about it that way. If we conduct a sovereign rating, we basically take a look at the economic soil of a country, its macroeconomic fundamentals. But we also have to ask the question, who is cultivating the economic soil of a country, right? Well, a country has many gardeners, and one of them is the government, so we have to ask the question, how is a country governed? How is it managed? And this is the reason why we have developed what we call forward-looking indicators. These are indicators that give you a much better read about the socioeconomic development of a country. I hope you would agree it's important for you to know if your government is willing to invest in renewable energy and education. It's important for you to know if the government of your country is able to manage a crisis, if the government is finally able to implement the reforms that it's promised. For example, if INCRA would rate South Africa right now, of course we would take a very, very close look at the youth unemployment of the country, the highest in the world. If over 70 percent of a country's population under the age of 35 is unemployed, of course this has a huge impact on the economy today and even more so in the future. Well, our friends at Moody's, Standard & Poor's, and Fitch will tell us we would take this into account as well. But guess what? We do not know exactly how they will take this into account.
And this leads me to the third big difference that INCRA would make. INCRA would not only release its ratings but it would also release its indicators and methodology.
So in contrast to the current system, INCRA would be fully transparent. So in a nutshell, INCRA would offer an alternative to the current system of the big three rating agencies by adding a new, nonprofit player to the mix that would increase the competition, it would increase the transparency of the sector, and it would also increase the quality.
I can tell that sovereign ratings may still look to you like this very small piece of this very complex global financial world, but I tell you it's a very important one, and a very important one to fix, because sovereign ratings affect all of us, and they should be addressed and should be defined as public goods. And this is why we are testing our model right now, and why we are trying to find out if it can bring together a group of able and willing actors to bring INCRA to life. I truly believe building up INCRA is in everyone's interest, and that we have the unique opportunity right now to turn INCRA into a cornerstone of a new, more inclusive financial system. Because for way too long, we have left the big financial players on their own. It's time to give them some company.