The Reciprocal Oversight Problem

• Author: Jeffrey Manns
• Position: Associate Professor, George Washington University Law School
• Pages: 1619-1671

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The Reciprocal Oversight Problem

Jeffrey Manns

ABSTRACT: Sovereign ratings are designed to mitigate investors’ risk

exposure by highlighting the fiscal condition of governments. The problem is

that sovereign ratings entail reciprocal oversight of rating agencies and

sovereign governments—which raises conflicts of interest and, ironically,

creates incentives for distorted risk assessments. Private rating agencies hold

sovereign governments accountable by assessing their risk exposure, while

sovereign governments hold rating agencies accountable through regulation.

Both sovereign governments and rating agencies have incentives to leverage

their mutual oversight to obscure risk taking and minimize accountability.

During booms, governments and rating agencies have convergent interests in

understating risks until market bubbles are on the cusp of bursting because

bubbles produce higher tax revenue and profits. During busts, both sides

blame one another for failing to accurately gauge risks, which fosters

regulatory stalemates that perpetuate the absence of public and private

accountability. Once the dust settles, the cycle of risk tolerance continues again

with neither set of actors providing meaningful oversight of the other as both

rating agencies and governments benefit from the renewed growth of the

financial sector.

Overseeing rating agencies is difficult for sovereign governments because they

face the temptation to abuse regulatory powers to neutralize rating agencies’

ability to push back and expose the fiscal overstretch of governments. The

simple alternative would be to utilize a self-regulatory organization approach

to balance the need for regulation with rating-agency independence. But the

stumbling block for self-regulation is that rating agencies are an oligopoly as

three firms account for 96% of ratings, and self-regulation could reinforce

the market power and entrenchment of the leading rating agencies. Instead,

this Article advocates an intermediation strategy of integrating a broader

array of ratings stakeholders into a stakeholder regulatory organization to

oversee the industry. A range of stakeholders rely on the accuracy and integrity

 Associate Professor, George Washington University Law School. I would like to thank

participants in faculty workshops at Tulane Law School, the University of Toronto La w School,

and the National Business Law Conference for their constructive comments.

1620 IOWA LAW REVIEW [Vol. 100:1619

of ratings and would have an interest in ensuring that rating-agency

regulation balances the need for greater procedural and substantive

accountability with the need for rating-agency independence from the

government. This approach would not deal with the other side of the coin—

the fiscal overstretch of sovereign governments that have exposed them to

increasing rating-agency scrutiny, which is a far more complex problem that

is beyond the scope of this Article. But the logic is that integrating end users

of ratings into deliberative processes will mitigate industry biases and produce

rules that preempt the need for government regulation.

I. INTRODUCTION ........................................................................... 1621

II. THE RECIPROCAL OVERSIGHT PROBLEM .................................... 1625

A. THE INHERENT CONFLICTS OF INTEREST FROM MUTUAL

OVERSIGHT ........................................................................... 1625

B. THE LIMITS OF SELF-REGULATION ......................................... 1629

C. THE CASE FOR A STAKEHOLDER REGULATORY

ORGANIZATION ..................................................................... 1632

III. THE CASE OF SOVEREIGN RATINGS ............................................. 1643

A. THE INHERENT DISCRETION IN SOVEREIGN RATINGS ............... 1646

B. THE CLASHES BETWEEN RATING AGENCIES AND THE U.S. AND

E.U. ..................................................................................... 1649

C. RESISTANCE TO TRANSFORMING RATING AGENCIES INTO A

REGULATED INDUSTRY .......................................................... 1653

D. THE CASE FOR A RATING-AGENCY STAKEHOLDER REGULATORY

ORGANIZATION ..................................................................... 1661

IV. CONCLUSION .............................................................................. 1670

2015] THE RECIPROCAL OVERSIGHT PROBLEM 1621

I. INTRODUCTION

Both government regulation and self-regulation of rating agencies suffer

from an inherent conflict of interest—the “reciprocal oversight problem.”1 A

dual principal–agent problem exists. Both sovereign governments and rating

agencies oversee one another and have incentives to leverage their oversight

roles to obscure risk taking and minimize responsibility for failure. The

problem is that rating agencies and sovereign governments have a convergent

interest in excessive risk taking during booms because each gains profits and

tax revenue respectively from fueling excessive optimism. But when booms

turn to busts, both sides blame one another and use their oversight roles to

blunt accountability. The reliance of governments and rating agencies on the

financial sector as an engine of growth means that once the bust subsides,

there are strong incentives to return to the status quo of risk taking without

effective public or private oversight. The result is a systematic failure of

government and rating-agency accountability due to the perverse incentives

created by mutual oversight.

The conventional understanding is that governments fail to exercise

effective oversight of rating agencies because of private sector capture of

regulators, or due to a failure to strike the right balance between government

and self-regulation.2 This Article argues that the roots of regulatory failure are

1. Most of the literature on the financial crisis (and earlier crises) has focused on the

conflicts of interests facing financial industry self-regulation, but has overlooked the conflicts of

interests of government actors and the impact of governments’ fiscal overstretch in distorting the

substance of regulation. See, e.g., William A. Birdthistle & M. Todd Henderson, Becoming a Fift h

Branch, 99 CORNELL L. REV. 1, 4–5 (2013) (discussing the creeping federalization of self-

regulatory organizations in the wake of the financial crisis); Kimberly D. Krawiec, The Return of

the Rogue, 51 ARIZ. L. REV. 127, 129–30 (2009) (critiquing “enforced self-regulation” by

highlighting how banks abused the flexibility regulators gave them to assess operational risks and

capital requirements); Jonathan R. Macey & Maureen O’Hara, From Markets to Venues: Securities

Regulation in an Evolving World, 58 STAN. L. REV. 563, 565–68 (2005) (analyzing the conflict of

interest between securities participants’ interests in effective self-regulation and their profit-

driven focus).

2. For example, “new governance” scholars have frequently famed the choice between self-

regulation and government regulation as a spectrum choice that entails ongoing negotiations

and give and take over policies and enforcement. See, e.g., Onnig H. Dombalagian, Self and Self-

Regulation: Resolving the SRO Identity Crisis, 1 BROOK. J. CORP. FIN. & COM. L. 317, 323–24 (2007)

(discussing the enduring appeal of self-regulation to securities and financial regulators as a

strategy for outsourcing regulatory burdens and costs to the private sector); Cristie L. Ford, New

Governance, Compliance, and Principles-Based Securities Regulation, 45 AM. BUS. L.J. 1, 29–36 (2008)

(applying the assumptions underpinning “new governance” scholarship to securities regulation

and arguing that the dynamic interaction between government regulators and self-regulatory

organizations gives both sides “incentives to be trustworthy and open with the other”); Jody

Freeman, The Private Role in Public Governance, 75 N.Y.U. L. REV. 543, 548–50 (2000) (framing

the interface of government and self-regulation “as a set of negotiated relationships” between the

public and private sector); Roberta S. Karmel, Should Securities Industry Self-Regulatory Organizations

Be Considered Government Agencies?, 14 STAN. J.L. BUS. & FIN. 151, 153–55 (2008) (calling for self-

regulatory organizations to be treated as government actors because of the degree to which the

government delegates regulatory roles); Orly Lobel, The Renew Deal: The Fall of Regulation and the