Credit Rating Agencies: A Constitutive and Diachronic Analysis.

Credit rating agencies such as Moody’s and S&P (Standard and Poor’s) have been subject to close examination by policy-makers since the Enron bankruptcy of 2001. Enron operated through a complex set of companies linked by carefully timed payments. The agencies did not spot the precarious financial engineering lurking behind Enron’s books, and lost credibility when the company collapsed without any warning. Concerns about what the agencies do and how well they do it were subsequently greatly heightened by the onset of the global financial crisis in 2007. Concerns focused on the role of the agencies in the mortgage market and the transformation of illiquid housing loans into liquid securities. This market seemed to allow for the disconnection between the supply of housing lending to homeowners and the financial markets built around the housing market. This is what at the time was called the ‘originate and distribute’ model. Many observers have blamed the agencies for the elaborate financial engineering involved and have questioned both their competence and motives. The public panic about the agencies gave rise to new demands for regulation of what until recently has been a largely ungoverned industry. In this paper we argue these efforts to regulate rating agencies have been largely ineffective, bringing more heat than light to the challenge of governing the credit rating agencies. The current regulation of credit rating agencies is more in the nature of a tax than a carefully designed framework of rules which shape what the rating agencies do in the direction of desired outcomes that expand societal welfare. Indeed, the process of building a regulatory approach has been so drawn out that it now threatens to throw any future agenda of credit rating agency reform into disrepute. Why have governments not been able to regulate credit rating agencies like they regulate other institutions in the financial markets? Why is the regulation we have, or that may be contemplated, seemingly so insubstantial? What is missing in our understanding of the agencies that would allow for effective intervention? What is the problem and what could and should be done about the rating agencies? We argue that some of the reasons for this failure stem from the nature of rating itself, which seems to be poorly understood by regulators and by the financial industry. Rating agencies are not banks. Indeed, they are not financial institutions. But their specific characteristics seem lost on many trying to understand them and what they do. Beyond this important question about understanding what the agencies actually are and how they function, we argue that rule-making has focused on superficial regulative governance. Normally, this sets the boundaries on what the agencies can do, prohibits specific activities and sets penalties for infractions, although in rating it largely amounts to a licensing system. Most regulation is of this rule-making type. It works well in many areas. But it works badly for banks because of banks’ ability to engage in regulatory arbitrage (Rethel and Sinclair 2012). Banks tend to side-step the intent of the law and pursue their ends via other means the law has not prohibited. We think similar problems pervade rating, perhaps even more so because the agencies are not involved in financial transactions (which can be identified specifically for regulatory purposes). In this context, regulation needs to take a different form, which we call constitutive, and address the very purpose of the credit rating businesses. We claim this broader and deeper form of regulation has some hope of reforming credit rating agencies. The following section of the paper considers what rating actually is and how it works. The next section examines different approaches to rating agency regulation. This is followed by an explanation of why the traditional approach to regulation does not work well in relation to the rating agencies. Last, we set out our case for a constitutive framework for rating regulation before concluding with some thoughts on prospects for rating agency governance.