Eliminating regulatory reliance on credit ratings: restoring the strength of reputational concerns.

AuthorMostacatto, Bianca

TABLE OF CONTENTS INTRODUCTION I. ORIGINS OF CREDIT RATINGS: THE INFORMATION ASYMMETRY PROBLEM AS A BUSINESS OPPORTUNITY II. ECONOMIC ANALYSIS OF THE RATINGS BUSINESS: HOW DO REPUTATIONAL CONCERNS FAVOR RATINGS ACCURACY? III. GOVERNMENTAL INTERVENTION IN THE MARKET FOR RATINGS: THE BEGINNING OF THE PROBLEM IV. ANALYSIS OF THE EFFECTS OF RATINGS-DEPENDENT REGULATION ON THE FUNCTIONING OF THE REPUTATION MECHANISM AND THE ACCURACY OF RATINGS V. POSSIBLE REMEDIES FOR THE DISTORTIONS CREATED BY RATINGSDEPENDENT REGULATION AND THEIR LIMITATIONS: A REVIEW OF U.S. AND EU REGULATORY RESPONSES VI. ELIMINATING REGULATORY RELIANCE ON RATINGS: AVOIDING THE SAME OLD MISTAKES CONCLUSION INTRODUCTION

Credit rating agencies are creatures of the market. They arose to provide, for a profit, an alternative solution for the basic problem of information asymmetry in the relationship between issuers of debt securities and investors, thereby satisfying an already existing demand. As competitors to other producers in the business of information intermediation, they differentiated themselves by translating extensive and complex information regarding the relative

credit quality of an issue or issuer into a single, simple, and standardized letter-grade. By doing so, they made debt instruments all over the world--be it corporate, sovereign or structured finance--comparable as to their credit risk. To the extent that rating agencies were deemed independent from the issuers whose securities they rate, ratings were viewed as an easy and useful source of information.

These characteristics made ratings, from their inception, a success among investors. Also attracted by these same qualities--simplicity, comparability, and independence--governments soon started to adopt ratings in their regulations. (1)

Today, the use of ratings in regulation is widespread in the United States and, to a lesser but still significant extent, internationally. It ranges from the assessment of regulated investors' capital requirements or permissible investments (2) to the definition of issuers' access to less stringent disclosure or registration requirements in the banking, securities, and insurance sectors. The regulatory use of ratings eased oversight over regulated institutions, insofar as it allowed supervisors to outsource risk analysis by making use of third parties' judgments. From the perspective of market participants, it had the advantage of reducing regulators' discretion, making the process more objective and less prone to corruption or arbitrariness.

However, ratings-based regulation--i.e., legal norms that, like the above-mentioned examples, make use of or reference credit ratings to achieve their declared purposes--presupposes that ratings are accurate. Otherwise, the goals that regulation aims at achieving are compromised and the regulatory use of ratings becomes counterproductive. Such accuracy is said to be secured through reputational concerns: rating agencies depend on their reputation to continue in business and, therefore, have enough incentives to continue to accumulate reputational capital and to avoid actions that would risk it. This idea was well-expressed by Thomas McGuire, a former executive vice-president of Moody's, who said: "What's driving us is primarily the issue of preserving our track record. That's our bread and butter." (3) Yet, contradictorily, the world has seen in the past decades repeated examples of ratings inaccuracy. (4) The latest financial crisis provides a recent illustration, and led U.S. Representative Henry Waxman, in his capacity as Chairman of the House of Representatives Committee on Oversight and Government Reform, to declare that "[t]he story of the credit rating agencies is a story of a colossal failure." (5)

The result of the successive scandals in the last decade was the introduction of a comprehensive, costly system of regulation and oversight of rating agencies, particularly in the United States and in the European Union. Regulatory efforts aimed at improving rating accuracy by focusing on the solution of perceived problems such as identified sources of conflicts of interests, lack of transparency, and lack of accountability. Implicit in this policy choice is the recognition that rating agencies are indispensable gatekeepers, that reputation alone is insufficient in encouraging them to provide accurate ratings, and that, therefore, governmental intervention is justified on the grounds of market failure.

In this Article, I argue that reputational concerns have not been enough to guarantee accurate ratings because the market environment in which rating agencies operate was distorted by the introduction of ratings-based regulation. In other words, this Article intends to demonstrate that the accuracy of ratings is significantly compromised by the very existence of ratings-based regulation. In this context, rather than a market failure, it is more appropriate to recognize here a sign of governmental failure, leading to decreasing reliability of ratings.

It will be shown how reputation influences the rating business and exactly why, in the presence of ratings-based regulation, reputation could not (and cannot) be counted on as a sufficient incentive for rating accuracy. It is often argued that reputational concerns are a constraint for rating dishonesty (i.e., the intentional attribution, by a rating agency, of a higher than deserved rating to an issuer or issue) because any financial gain received by an agency from any particular issuer is likely to be too small to compensate for the risk of losing reputation and, thus, long-term revenue. (6) Contrary to this common view, I will demonstrate that the trade-off faced by rating agencies is greatly influenced by factors such as the qualitative and probabilistic nature of ratings--which influences the probability of wrongdoing detection and punishment--and, especially, the governmental use of ratings in regulation. The latter creates a captive demand for ratings and effectively insulates them from market discipline, while also distorting the incentives of market participants and creating a demand for inaccurate ratings. The combined influence of these and other factors, to be delineated in Parts II and III, is that the trade-off faced by rating agencies is affected in such a significant way that the reputation mechanism--i.e., the pressure exercised by reputational concerns towards fostering ratings accuracy--becomes potentially ineffective even in the face of a non-substantial, immediate financial gain. With much more reason, substantial gains such as the revenues received by rating agencies related to the business of structured finance (7) are almost certain to induce dishonesty or ratings laxity--i.e., "wishful thinking" as to the deservedness of a high rating by an issue or issuer.

Understanding the functioning of the reputation mechanism and its limitations under the current legal framework is essential to effectively tackle the problem of rating inaccuracy and its consequences for the functioning of capital markets. I will argue that the recently introduced system of regulation and oversight of rating agencies is not only costly, but imperfect in securing rating accuracy, and I will explain why only the restoration of the reputation mechanism, including the elimination of ratings-based regulation, is capable of achieving the goal of effectively encouraging rating agencies to perform their important role as capital markets' gatekeepers. Likewise, eliminating regulatory reliance on ratings (i.e., ratings-based regulation), followed by deregulation of the rating business itself is the only effective way of promoting innovation and competition in the business of information intermediation and, as a consequence of a larger supply of competing informational products, improving the management of risk by regulated and non-regulated investors.

There is another reason why understanding the factors that led to the inefficacy of reputational concerns is indispensable. Regulators all over the world are now contemplating ways to reduce or eliminate regulatory reliance on ratings, (8) based on reasons such as the need to prevent cliff effects and systemic risk. In such a sensitive time, in which new government interventions--through regulation--are about to be implemented, it is important to have a clear view of the mistakes that lead to the chronic incentive problem in the ratings market and the lessons drawn from the unintended effects of ratings-based regulation. Among other things, recognizing how the regulatory use of ratings affected the incentive structure of market participants is indispensable to avoid their mere substitution for a benchmark that might cause the same sort of problems.

This work proceeds in the following manner: Part 1 provides an overview of the spontaneous origin of ratings as a market solution to the problem of information asymmetry. In Part II, a closer look is taken at how the reputation mechanism works as a constraint to deliberate rating inaccuracy and specific factors involved in agencies' trade-off, as well as general limitations to the effectiveness of this mechanism in the ratings business. Part III briefly reports how indirect governmental intervention in the ratings market, through ratings-based regulation, took place while also providing an overview of the most-common regulatory uses. Part IV follows, analyzing the effects of these regulations on the functioning of the reputation mechanism and the accuracy of ratings. In Part V, the main policy routes to improving rating accuracy are analyzed, including regulation and oversight of agencies, increased competition, civil liability of agencies, and elimination of regulatory reliance. It is then clarified why the latter is a superior means to ensure agencies' honesty and rating accuracy. Part VI draws from the previous analysis lessons that regulators should observe when...

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