Private Ordering of Public Markets

The Rating Agency Paradox

In this article, Professor Schwarcz examines the role of rating \\"agencies\\" in ordering financial markets in the United States and abroad. Though rating agencies are largely unregulated private entities, they significantly influence the global economic system. Recent international proposals regarding the determination of capital adequacy guidelines for the banking industry call for an even greater role for rating agencies. In this light, Professor Schwarcz queries whether market forces provide sufficient restraint on rating agencies or whether public sector regulation is warranted. In the latter case, he also asks whether it is feasible for individual nations to regulate multinational entities of this type.The article initially addresses the functions, origin and terminology of rating agencies. Through the development and nearly universal acceptance of ratings, investors are able to assess the risk attendant to investments in public and privately issued debt securities. The article then addresses the issue of regulation, focusing on the competing regulatory goals of efficiency and distributional interests. Concluding that any regulation of rating agencies should be largely rooted in efficiency concerns, Professor Schwarcz posits that regulation could increase efficiency by either bolstering rating agency performance or mitigating negative consequences of rating agency misbehavior.Professor Schwarcz contends that regulation would not increase efficiency. Rating agency costs are not excessive, nor would increased regulation result in greater ratings reliability. Rating agencies are already motivated to provide accurate and efficient ratings because their profitability is directly tied to reputation. Conversely, additional regulation could possibly subject ratings to political manipulation, thereby impairing ratings reliability.The article also rejects the contention that regulation would mitigate any negative consequences of rating agency misbehavior. Although the practice of requiring issuers to pay for a rating raises a potential conflict of interest, Professor Schwarcz argues that the risk of misbehavior is minimal and is largely deterred by the potential impact on reputation costs. He also argues that reputation can be a substitute for regulation, and that, at least for rating agencies, reputation drives much of the accountability that ordinarily is achieved through the democratic process.Regulation of rating agencies is also unlikely to resolve their traditionally conservative bias against innovative new financial structures. Government regulation may in fact increase the bias by reducing competition among rating agencies. Moreover, given the international nature of rating agencies and the fact that their assets are human capital, regulation by individual nations could drive rating agencies to relocate to foreign nations that do not impose regulation. Professor Schwarcz concludes that public regulation of rating agencies is an unnecessary and potentially costly policy option.*Professor of Law, Duke Law School; Faculty Director, Duke Global Capital Markets Center; Professor (Adjunct) of Business Administration, Fuqua School of Business.

The full text of this Article is available to download as a PDF.