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
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 …