The Reciprocal Oversight Problem

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

To continue reading

FREE SIGN UP