Regulation of Credit Rating Agencies: Why and How?

“Credit rating agencies are the biggest uncontrolled power in the global financial system, and thus in the national financial system too,” said the President of the Federal Financial Supervisory Authority (BaFin) as early as 2003 at a hearing before the German parliament's finance committee (Deutscher Bundestag 2003). In the US too, a growing number of voices argued for CRAs to be regulated in the wake of the Enron and WorldCom affairs. The calls for regulation that emerged during the present financial crisis and the measures now introduced did not therefore come out of the blue. Nevertheless, it is often unclear what the regulation of CRAs is intended to achieve.

One of the reasons for this is almost certainly that ratings fulfill several roles in the international financial markets. The question of whether and, if so, how CRAs should be regulated is therefore determined not least by the numerous potential areas of conflict with the state. If CRAs are regarded as normal companies, the focus will be on the lack of competition and efficiency arguments. If ratings-based regulation is taken as the starting point for consideration of the issue, the state will be interested in a smoothly functioning, reputable system delivering ratings of high quality. Conflicts of interests that adversely affect quality are also a concern. In addition, ratings make it easier to establish and enforce legal rights (see Gonzalez et al. 2004). And if the financial system as a whole is considered, structural problems such as exacerbating procyclicality will play a role. The various arguments for regulating CRAs have been described extensively in academic literature and need not be pursued further here (see, for example, Dittrich 2007; Emmenegger 2006; Hill 2004).

The financial crisis has revealed elements justifying regulation in all of the above functions performed by ratings. Where structured products were concerned, information asymmetry was reduced far less than investors had anticipated. The gatekeeper role led to conflicts of interests and the use of ratings both to enforce legal rights and for prudential purposes increased procyclicality.

Any approach to regulating CRAs must therefore address the question of what should be regulated and with which tools—in other words how. Regulation will only succeed if it takes account of what ratings can and cannot achieve. A rating of a financial instrument provides information about the credit quality, i.e., the probability of default, of a specific company or financial product. It says nothing about “systemic risk”—that is to say the danger of a chain reaction resulting in a number of financial institutions getting into difficulties.

It may thus be concluded that, while it may be perfectly rational for individual firms and institutional investors to be guided by a rating when making their investment decisions, these decisions can destabilize the financial markets at a systemic level if downgrades and rating triggers result in mass selling, write-downs, and additional capital requirements. The key point determining whether systemic risk arises is consequently the extent to which individual defaults occur at the same time. Ratings provide no information about this. Hence, it would be a mistake to believe that regulating CRAs could have mitigated procyclicality. Regulating credit rating agencies can do nothing to solve the problems caused by using ratings for regulatory purposes. Lawmakers should therefore refrain from overreacting. Instead, they should consider enhancements to current regulation that will work in a prosperous economy as well as in challenging times.

Conversely, the objective of regulating CRAs can only be to make ratings more reliable and mitigate conflicts of interests. On the question as to how to achieve this objective, there is broad consensus that rating methodologies should not be monitored. This is not only for competitive reasons, but above all because regulation of this kind could result in the state being considered partly responsible for published ratings. This would be incompatible with the concept of private-sector credit rating agencies. Given that states themselves are also issuers of debt, moreover, a new conflict of interests would arise if the state were in a position to influence the methodologies used for assigning sovereign ratings.

The range of possible methods of regulation nevertheless remains extremely broad. At one end of the spectrum is the idea that CRAs should regulate themselves. At the other end, there are demands for the rating process to be entrusted to the public sector. Support for the latter solution is not only to be found on the political left;⁶ it is evidently also favored by some academics. For instance, in an article published on 14 May 2009 on Spiegel-Online, the Internet edition of a German news magazine, the German economics professor and member of the German Council of Economic Experts Peter Bofinger called for the introduction of state credit rating agencies to prevent misjudgments of the kind made before the present financial crisis (Spiegel-Online 2009).

Between self-regulation and state credit rating agencies lies the model of state-regulated private-sector CRAs. While the introduction of state agencies may be excluded simply for the reason that the state would then also have to assume liability for ratings, the other two alternatives remain the subject of heated discussion. For a long time, policymakers accepted the arguments against state regulation. In Europe, it was only the present financial crisis that led to reconsideration.

From a market economy perspective, there is much to be said for self-regulation, i.e., allowing CRAs to set their own code of conduct. However, the success of any self-regulatory regime stands or falls with the question of control. First, there needs to be effective supervision to reveal deviations from the self-imposed rules. Second, there must be a mechanism to sanction deviations. Self-regulation in the credit rating industry is only an option if it fulfils both requisites. The obvious supervision tool is rating quality (see Dittrich 2007: 147). This is an instrument that can be easily monitored by market participants and the media. And investors, for their part, will only accept reliable ratings over the long term. The second requisite is also met by the quality criterion. CRAs are highly sensitive to poor informational quality and proven anticompetitive behavior because both lower issuers' willingness to buy ratings. A loss of reputation will endanger the business of any CRA, so it is a highly effective form of sanction. The supporters of this hypothesis—and these include the vast majority of market participants—have considered self-regulation on the basis of the IOSCO Code sufficient up to now.

For the advocates of state regulation, a key lesson to be learned from the current turmoil is that it is vital for ratings to be able to provide a reliable indication of a debtor's creditworthiness even in times of crisis. In their view, the present crisis proves that the self-disciplining role played by reputation cannot always be relied on and only functions over the long term. Self-regulation does not work effectively when the pressure of reputation as a controlling power exists only to a limited degree due to a lack of competition (see Blaurock 2007). In addition, the argument goes, a rating does not only buy an issuer information. It should not be forgotten that ratings also regulate market access. Against this backdrop, CRAs have not managed to demonstrate that they are able under the existing regime to successfully resolve conflicts of interests. State regulation advocates feel that, in the interest of financial market stability, the current market failure justifies state regulation.

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