Rating Agencies in the Face of Regulation

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, March 29, 2010.

In our paper, Rating Agencies in the Face of Regulation – Rating Inflation and Regulatory Arbitrage, which was recently made publicly available on SSRN, we develop a rational expectations framework to analyze how rating agencies’ incentives are altered when ratings are used for regulatory purposes such as bank capital requirements. Rating agencies have been criticized by politicians, regulators and academics as one of the major catalysts of the 2008/2009 begin_of_the_skype_highlighting              2008/2009      end_of_the_skype_highlighting financial crisis. One of the most prominent lines of attack, as voiced by Henry Waxman, is that rating agencies “broke the bond of trust” and fooled trustful investors with inflated ratings. However, should sophisticated financial institutions be realistically categorized as trustful and fooled investors in light of the fact that they interacted with rating agencies not only as investors but also as originators of subprime mortgage securities? Why would these institutional investors care about ratings when they knew about rating agencies’ practices?

We argue that a first-order benefit of a high rating stems from financial regulations, such as minimum bank capital requirements. Over the last 20 years bank capital requirements (Basel I guidelines (1988) and Basel II guidelines (2004)) have become increasingly reliant on ratings as a measure of risk. For example, banks must hold five times as many reserves against BBB+ securities than against AAA securities. Moreover, the investment-grade threshold and the AAA threshold have become regulatory investment restrictions for pension and money market funds. Since these regulations are of first-order relevance for institutional investors’ capital management, a AAA label is economically valuable, independently of the underlying information it provides about the risk of a security…(continue reading)

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