Public-Private Pathology:

The Failures of Credit Rating Agency Reform              

RISHI AHUJA

SENIOR HONORS THESIS

CHARLES AND LOUISE TRAVERS DEPARTMENT OF POLITICAL SCIENCE

UNIVERSITY OF CALIFORNIA, BERKELEY

MAY 2015    

       

       

     

 

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Abstract:   How did credit rating agencies (CRAs) in the United States escape fundamental

regulatory reform after failing to evaluate credit risk leading up to the financial crisis of 2008? In

this paper, I argue that previous regulatory decisions that delegated risk analysis to CRAs

resulted in a lack of relevant expertise in federal regulatory agencies, the development of

expertise in the private sector, and the spread of dependence on CRAs to multiple arenas of

public policy at the state and federal level. These factors coalesced to limit the scope of potential

policy options after the crisis by increasing the cost of alternative policy solutions and creating

doubt in both the private and public sector that the federal government could effectively take on

a larger regulatory role, biasing reform debates towards maintaining the status quo. This process

centered on two key junctures. First, in 1936 federal regulators empowered CRAs to determine

what were “investment grade” bonds for the purposes of federal rulemaking. Second, in 1975

federal regulators codified systemic dependence on CRAs through the creation of Nationally

Recognized Statistical Rating Organizations (NRSROs). These two crucial steps solidified a

deeply entrenched system that proved impossible to overturn after the crisis, resulting in

superficial reforms in 2006 and 2010 that failed to address the fundamental regulatory challenges

posed by CRAs.  

     

                 

   

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Table  of  Contents    

I)  Introduction……………………………………………………………………………………………………………….  4      

A) The  Financial  Crisis  and  the  Lack  of  Reform    

B) Historical  Background  and  Policy  Structure    

C) Overview        

II)  Argument………………………………………………………………………………………………………..………..11    

A) Argument      

B) Independent  and  Dependent  Variables    

C) Alternative  Hypotheses                  III)  Evidence………………………………………………………………………………………………………….......22  

 A) Evaluating  Qualitative  Evidence  

   B) Creating  Regulatory  Dependence:  1930-­‐1975  

 C) Legitimizing  Regulatory  Dependence:  1975-­‐1985    

   

IV)  The  Failure  of  Reform……………………………………………………………………………………….……..43    

A) Introduction        

B) 2006  Credit  Rating  Agency  Reform  Act    

C) 2010  Dodd-­‐Frank  Wall  Street  Reform  and  Consumer  Protection  Act                    V)  Conclusion………………………………………………………………………………………………………………..59    

 VI)  Work  Cited………………………………………………………………………………………………………………63  

     

 

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Chapter  I:  Introduction    

 In April of 2007, two Standard and Poor’s (S&P) analysts were discussing the merits of an

on-going deal.1 One analyst stated that the deal was “ridiculous” and that S&P “should not rate

it.” In response, the other analyst retorted: “It could be structured by cows and we would rate it.”

Just months later, Moody’s alone had to downgrade 36,346 tranches of debt due to the fact that

the original ratings assigned were gross misrepresentations of the actual risk of the instruments.2

In fact, a third of the downgrades that took place featured AAA ratings – the highest rating of

safety given to an asset.3 The inability of CRAs to effectively measure credit risk, and the private

and public sector’s dependence on the accuracy of their ratings, was a central driver of the 2008

financial crisis.

CRAs are charged with an important role in the market economy: to accurately assess the

risk of financial instruments and to inform potential investors that may be seeking to purchase

those instruments. This role, since the 1930’s, has extended into public policy as the federal

government began to rely on the ratings produced by CRAs when evaluating the safety and

soundness of financial institutions, assets, insurance plans, and a whole spectrum of financial

products. During the financial crisis, however, the top three firms in the market (Moody’s, S&P,

and Fitch) unequivocally failed at this task. Furthermore, these three firms make up 95% of the

market.4

After the crisis, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection

Act (Dodd-Frank) in July of 2010 brought about numerous regulatory reforms to the financial                                                                                                                1 David McLaughlin, “S&P Analyst Joked of Bringing Down the House Before the Crash,” BloombergBusiness, 2 Efraim Benmelech and Jennifer Dlugosz, “The Credit Rating Crisis,” NBER Macroeconomics Annual 2009, Volume 24 (2010), 161. http://www.nber.org/chapters/c11794.pdf. 3 Benmelech and Dlugosz, “The Credit Rating Crisis,” 161. 4 Christopher Alessi, "The Credit Rating Controversy," Council on Foreign Relations, February 19, 2015, http://www.cfr.org/financial-crises/credit-rating-controversy/p22328.

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sector, but did little to alter the prominent role of CRAs. Dodd-Frank mandated that the

Securities and Exchange Commission (SEC) issue new rules regarding the regulation of CRAs.

Though hotly contested, many consumer advocates and policy analysts found the proposed

changes to be lackluster at best. According to the Consumer Federation of America, the proposed

rules “did not match the scale of the problem they were intended to address… nor did they

deliver the full scope of the credit rating agency reforms that Congress intended when it adopted

the Dodd-Frank Act.”5 According to the World Bank, “the regulatory treatment of rating

agencies has been paradoxical: regulatory standards have been predicated on credit ratings but

there has been little direct oversight of how the ratings are made.”6 Furthermore, this legislation

directly followed the Credit Rating Agency Reform Act of 2006 (Reform Act of 2006) that

sought to curb regulatory challenges with CRAs, making Dodd-Frank the second failed attempt

to produce widespread reform.

Why did policy-makers only pass superficial CRA reform after the 2008 financial crisis?

In this paper, I present a path dependence model that illustrates how previous decisions to

outsource regulatory authority to CRAs produced two central effects that limited the scope of

potential reform after the financial crisis. First, federal regulatory actors grew dependent on

CRAs to assess credit risk and thus did not build the skills or capacity to fulfill this central roll,

while this expertise grew in the private sector. Second, the decision to outsource risk evaluation

to CRAs at the federal level carried over into federal and state legislation and rules governing a

host of other policy issues in finance and insurance regulation. These two effects of regulatory

                                                                                                               5 Gretchen Morgenson. “The Stone Unturned: Credit Ratings,” The New York Times, March 22, 2014. http://www.nytimes.com/2014/03/23/business/the-stone-unturned-credit-ratings.html. 6 Jonathan Katz, Emanuel Salinas, and Constantinos Stephanous, “Credit Rating Agencies: No Easy Regulatory Solutions.” The World Bank Group, Financial and Private Sector Development Vice Presidency, Crisis Response Policy Brief 8 (2009). http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1303327122200/Note8.pdf

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outsourcing limited the scope of potential reform by increasing the cost of broader government

oversight and convincing both the private and public sector that the federal government was unfit

to measure credit risk. Though the initial hearings of Dodd-Frank proposed bold changes to the

structure and role of CRAs, the final law and rules illustrate the lasting impact of decades of

dependence. CRAs have maintained their stranglehold as the only legitimate assessor of asset

risk, primarily due to the historical dependence that was created through federal policy and rule-

making in the 1930s and 1970s. Grasping the historical process of dependence, as opposed to

purely studying the current politics of financial regulation, is central to understanding the

outcomes of Dodd-Frank.

A) The Financial Crisis and the Lack of Reform

The lack of CRA reform is puzzling due to the dramatic failure of these institutions to

accurately assess credit risk during the crisis. The financial crisis, as thoroughly documented in

the media, academia, and policy-circles, had a devastating effect on the global economy. At its

peak, domestic unemployment spiked to 10.1% and was accompanied by a sharp decline in

domestic product.7 Furthermore, a Federal Reserve study found that 63% of American household

wealth declined as a result of the 2008 crisis.8 Globally, the crisis produced a 12.2% contraction

in global trade – sending ripple effects through both the developed and developing world.9

During the fourth quarter of 2009, the E.U. and Asia saw a decline in exports of 16% and 5%

                                                                                                               7 Bureau of Labor Statistics, U.S. Department of Labor, 3/1/2015, http://data.bls.gov/timeseries/LNS14000000. 8 Jesse Bricker, Brian Bucks, Arthur Kennickell, Traci Mach, and Kevin Moore (2011): “Surveying the Aftermath of the Storm: Changes in Family Finances from 2007 to 2009,” FEDS Working Paper 17, Federal Reserve Board, http://www.federalreserve.gov/pubs/feds/2011/201117/201117pap.pdf. 9 World Trade Organization. “World Trade Organization Annual Report 2010,” (2010), https://www.wto.org/english/res_e/publications_e/anrep10_e.htm.

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respectively.10 The crisis wrecked havoc on a global scale – causing immense harm to millions of

everyday consumers far removed from the complex debt obligations at the center of the collapse.

By failing to accurately assess the safety of financial assets, CRAs enabled financial institutions

and investment funds to take on high levels of risk that eventually collapsed, resulting in

widespread consumer harm.

Furthermore, the financial regulatory system’s dependence on CRAs is also puzzling due to

the fact that evaluating the credit risk of financial institutions is clearly under the purview of

federal regulatory agencies. According to the Federal Reserve, “A key goal of banking regulation

is to ensure that banks maintain sufficient capital to absorb reasonably likely losses.”11 To

evaluate whether a bank has “sufficient capital,” the Federal Reserve must have clear metrics for

evaluating the riskiness of a bank’s leverage, investments, and strategic positions. Similar

language can be found in a variety of other federal and state regulatory descriptions. Given the

fundamental nature of credit evaluation, it seems counterintuitive that this role was outsourced to

the private sector.

Lastly, previous attempts at major financial regulatory policy in the wake of a financial crisis

have yielded significant results. The last piece of holistic financial regulatory legislation, The

Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley), created significant changes in the public

accounting industry in light of a host of corporate governance scandals. Sarbanes-Oxley created

the Public Company Accounting Oversight Board, stricter definitions and criteria for auditor

independence, stricter penalties for corporate fraud, and higher standards for disclosure.12 In the

                                                                                                               10 World Trade Organization. “World Trade Organization Annual Report 2009,” (2009), https://www.wto.org/english/res_e/publications_e/anrep09_e.htm.  11 Federal Reserve System Publication Committee, “The Federal Reserve System: Purposes and Functions,” (2005), http://www.federalreserve.gov/pf/pdf/pf_complete.pdf.  12 Bernhard Kuschnik, “The Sarbarnes Oxley Act: ‘Big Brother is Watching You’ or Adequate Measures of Corporate Governance Regulation?” Rutgers Business Law Journal, (2008), http://businesslaw.newark.rutgers.edu/RBLJ_vol5_no1_kuschnik.pdf

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case of Dodd-Frank, similar scrutiny was not applied to CRAs. Though Dodd-Frank removed

references to CRAs in federal regulation and agency rules, the law did not give the SEC broad

authority to scrutinize the practices of CRAs or to fully replace them and conduct internal risk

analysis for the purpose of federal regulation. Furthermore, while the securities industry poured

in $100,207,423 in 2013 towards lobbying the federal government, the three largest CRA’s paid

approximately $2,220,000 total in the same calendar year – a paltry sum in comparison.13 This

raises questions as to whether traditional forms of regulatory capture by the private sector are

applicable to the example of CRAs and the lack of reform after Dodd-Frank.

B) Historical Background and Policy Structure

It is crucial to establish the historical setting that influenced the regulatory environment for

CRAs. The first CRAs arose to address the basic need for information as investors became

spatially distant from the products they sought to invest in.14 As noted by Richard Sylla, the

desire for information regarding the soundness of investments in new railroads during the

booming expansion of the late 19th and early 20th century provided the back drop for the creation

of the first bond rating agency by John Moody in 1909.15 Shortly after, Poor and Fitch joined the

industry in 1916 and 1924 respectively and the three firms quickly consolidated market share.

CRAs played an important role in easing informational asymmetry between investors and those

seeking capital, serving as a third-party that could provide impartial risk evaluations for

investors. The incentives for these firms were also aligned to produce quality information: if the                                                                                                                13 Center for Responsive Politics, Open Secrets, Lobbying expenditures by the Securities Industry, (2013): https://www.opensecrets.org/lobby/indusclient.php?id=F07&year=2013. Lobbying Expenditures by Moody’s, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000043203&year=2013. Lobbying Expenditures by S&P, (2013): https://www.opensecrets.org/lobby/clientsum.php?id=D000035733&year=2013. Lobbying Expenditures by Fitch, (2013): http://www.opensecrets.org/lobby/clientsum.php?id=D000050935&year=2013. 14 Richard Sylla, “A Historical Primer on the Business of Credit Ratings.” The World Bank, Washington, DC, (2001), 7, http://www1.worldbank.org/finance/assets/images/Historical_Primer.pdf. 15  Richard  Sylla,  “A  Historical  Primer  on  the  Business  of  Credit  Ratings.”  6.        

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investor found the information untrustworthy or unprofitable, the investor could opt to pay

another CRA for information.

It is also important to clarify the major actors in the financial regulatory systems during the

financial crisis of 2008. Several agencies are responsible for evaluating the safety and soundness

of the nation’s financial system.16 The central regulator for the securities industry, the SEC,

promulgates rulemaking over securities markets and establishes the guiding principles

surrounding the exchange of assets. The Commodity Futures Trading Commission oversees the

market for futures (contracts regarding the future sale of an asset) and options (contracts

regarding the purchase of the “option” to buy or sell a given asset at a particular price point). The

Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency (OCC), and

the Federal Reserve, all seek to regulate financial institutions of various sizes and levels of

complexity to ensure legal compliance and stability in the financial markets. Up until Dodd-

Frank, the Office of Thrift Supervision also participated in prudential regulation and has been

since combined with the OCC.

C) Overview

In Chapter II, I will lay out my hypothesis that path dependence offers the best

mechanism to explain the lack of regulatory reform after the crisis through two primary

mechanisms. First, the lack of skills development at the federal level due to the decision to

outsource regulatory responsibility in the 1930’s eroded trust in a larger role for the federal

government in evaluating asset safety and credit risk. Furthermore, the decision to outsource

                                                                                                               16 For a more robust breakdown of the federal regulatory framework, see Edward Murphy. “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets.” Congressional Research Services. (2013), http://digitalcommons.ilr.cornell.edu/cgi/viewcontent.cgi?article=2154&context=key_workplace.

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regulatory authority to CRAs spread to multiple policy arenas at the federal and state level,

increasing the cost of alternative policy structures. Additionally, I will highlight the foundations

for this hypothesis in the literature as well as competing hypotheses that seek to explain the lack

of reform. Chapter III will delve into the path dependence model, examining the historical

evidence of regulatory outsourcing in the 1930s and 1970s that created a lack of relevant federal

expertise as well as the spread of regulatory outsourcing to CRAs across multiple policy arenas.

In Chapter IV, I will examine the aftermath of the path dependence model – the lack of reform

exhibited by both the Reform Act of 2006 and Dodd-Frank. Lastly, I will provide an overview of

the analysis presented, concluding remarks, and potential directions for future research.

                                                       

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Chapter  II:  Argument      

In this section of the paper, I seek to describe the theoretical underpinnings of the path

dependence model that I will utilize to examine the lack of regulatory reform after the financial

crisis of 2008. First, I will lay out my model of path dependence, specifically focusing on an

“increasing returns” perspective as described by Paul Pierson, and place this model in the context

of the path dependence literature. Second, I will identify the independent and dependent

variables that interact through this process and the evidence I will use to examine the

development of regulatory dependence. Lastly, I will evaluate potential alternative hypotheses in

the literature and how they may address the research question at hand.

A) Argument    

In this paper, I argue that a path dependence model provides a robust explanation of why

CRAs avoided effective regulatory reform after the financial crisis of 2008. The historical path

limited the scope of future regulation primarily through two mechanisms. First, after initially

allocating regulatory authority to CRAs in the 1930s, federal regulators failed to develop the

internal expertise to analyze the safeness of assets. This lead to the SEC being unwilling and ill

equipped to play a larger role in overseeing securities markets after both the Enron scandal of

2001 and the financial crisis of 2008. Private and public actors, as a result of this allocation of

regulatory responsibility in the 1930’s, developed a deep distrust of the government taking a

larger role in overseeing an increasingly complex securities market. Second, regulatory

outsourcing to CRAs spread over time into a variety of policy spheres at the state and federal

level. The spread of dependence on CRAs throughout multiple policy arenas increased the cost

of effective reform. For the federal government to play a larger role in evaluating asset risk,

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dozens of laws and rules at the state and federal level needed to be substantively altered. The

confluence of both of these factors biased reform debates, and the eventual laws, towards

maintaining the status quo.

The path dependence model presented in this paper takes place in two distinct phases. First,

in the 1930’s, federal regulators codified structural dependence on CRAs to evaluate the

soundness of bank investments and defer, for the first time, to their ratings when assessing the

safety of financial institutions. Second, in the 1970’s, federal regulators furthered this

dependence, systemizing the role of CRAs as NRSROs and fully allocating regulatory

responsibility to these organizations. In outsourcing regulatory responsibility to CRAs, regulators

did not develop the capacity and skills needed to carry out this role internally. Furthermore, this

dependence was established in other state and federal laws and regulatory rules in a host of other

areas of financial and insurance oversight. This lead to an increase in switching costs in that

pursuing an alternative regulatory structure would involve undoing decades of dependence and

building new internal capacity from the bottom up. Faced with these challenges, Congress and

the SEC opted to make minor changes as opposed to instituting a bold set of reforms. To

understand the effects of these two historical junctures, I will assess the scope of reforms

proposed by both the 2006 and 2010 laws and their corresponding outcomes.

To ensure that my model of path dependence does not simply recap the regulatory history, I

will employ an “increasing returns” perspective on path dependence as offered by Paul Pierson.17

Adopting this model will enable me to be more precise in teasing out causal relationship in the

evidence. Under this model, path dependence manifests itself if the following criteria are present:

1) multiple equilibria – a wide range of outcomes are possible at the onset of policy decision-

                                                                                                               17 Paul Pierson, “Increasing Returns, Path Dependence, and the Study of Politics,” The American Political Science Review, Vol. 94, No. 2 (2000), 251-267, http://www.unc.edu/~fbaum/teaching/PLSC541_Fall06/Pierson%20APSR%202000.pdf.

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making, 2) contingency – small events have major policy impacts, 3) timing and sequencing –

when an event occurs is of great importance, and 4) inertia – once a policy choice has been

made, an equilibrium develops that is challenging to change. This framework helps constrain

broad historical arguments around a narrower confine of factors that help drive path dependent

relationships between historical junctures.

B) Independent and Dependent Variables

Path dependence can be operationalized to understand the lack of reform in Dodd-Frank

and the subsequent rule-making pertaining to CRAs. In this model, the independent variables are

the various historical events, particularly in the 1930’s and 1970’s, that eventually had a causal

effect on the outcome of interest: the lack of reform for CRAs in both the Reform Act of 2006

and Dodd-Frank. Thus, the dependent variable in this model is the regulatory outcome. I argue

that the two central independent variables were the policy decisions to initially create regulatory

dependence in the 1930’s and the further ossification of that dependence in the 1970’s. The

dependent variables of interest are the regulatory outcomes of both the Reform Act of 2006 and

Dodd-Frank.

Applying this framework, the evidence in this paper illustrates that regulatory

outsourcing to CRAs lead to a lack of actual and perceived expertise at the federal level and

spread to multiple policy spheres. Thus, in both critical historical junctures, I will provide

evidence that indicates a growing lack of internal expertise to analyze risk by federal regulators

as the financial sector, and the role of CRAs, grew in complexity. Additionally, I will identify

various areas of policy where dependence on CRAs was codified during the historical junctures.

These initial historical facts, however, only influenced the subsequent policy-making decisions if

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they constrained the set of potential options in a direct fashion. Thus, legislative hearings and

debates during both the Reform Act of 2006 and Dodd-Frank must show that historical

dependence bound the scope of policy alternatives. More specifically, policy alternatives must be

bound by the lack of internal expertise and the proliferation of CRAs across multiple policy

realms. For the evidence to support my hypothesis, regulators and public sector actors must show

hesitancy and concern regarding a larger role for federal government oversight into an area that

they lack long-established expertise, as well as references to the cost of undoing the deeply

embedded nature of dependence on CRAs.

C) Alternative Hypotheses

Additionally, it is important to identify potential alternative hypotheses that seek to

explain why regulatory reform of CRAs failed. The most significant alternative hypothesis in

relation to my argument is that the regulatory history simply does not matter. If the regulatory

outcome of the Reform Act of 2006 and Dodd-Frank can be purely explained by the politics,

influence, or other factors that were unique to the passage of both laws and not dependent on

previous historical developments, then a path dependence model provides little utility in

understanding the regulatory outcome. The two primary alternative explanations that embody

this principle include the politics of regulatory and cultural capture in addition to the creation of

privileged positions in the regulatory process. It is important to note that these two alternative

hypotheses are not mutually exclusive in regards to the hypothesis I am proposing: regulatory

decisions are complicated processes with historical policy developments blending with the

current political dynamics. The central question, however, is which hypothesized process had the

greatest influence on the final outcomes of the Reform Act of 2006 and Dodd-Frank.

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One potential alternative explanation for the lack of reform is that the regulatory actors in

charge of overseeing CRAs were “captured” by private interests. Capture theories apply scrutiny

to the regulatory bodies in charge of policy implementation and provide insight as to why

regulatory bodies, and the SEC in particular, failed to substantially retool CRA oversight.

Capture arguments are primarily focused on the dynamics of regulatory application – seeking to

understand the intricacies of the relationship between the regulator and regulated body. In the

case of CRAs, capture arguments could relate both to CRAs directly capturing the SEC’s

decision making or to large financial institutions utilizing their influence to subvert effective

regulatory reform of CRAs to preserve the status quo that had proved historically profitable. An

argument of regulatory capture could have nothing to do with the history of regulation and

everything to do with the politics of both reform bills – rejecting my contention that the historical

path is the most significant factor in understanding the dependent variable (regulatory outcomes

of the Reform Act of 2006 and Dodd-Frank).

This school of thought can be evaluated through two lenses: regulatory capture and cultural

capture. Regulatory capture describes a scenario where “regulation, in law or application, is

consistently or repeatedly directed away from the public interest and towards the interest of the

regulated industry, by the intent and action of the industry itself.”18 Under this framework, CRAs

avoided substantial regulatory scrutiny after the financial crisis through the traditional means of

interest group influence – firms provide support to legislators who in turn pressure regulatory

bodies to ease regulation or industry regulators frequent through the revolving door into private

sector positions in the industry. Or, more simply, the regulator and regulated industry

participants were too close, leading to suboptimal levels of regulatory scrutiny. Carpenter and

                                                                                                               18 Daniel Carpenter and David A. Moss, Preventing Regulatory Capture: Special Interest Influence and How to Limit It (Cambridge: Cambridge University Press, 2014), 1-22 and 451-66.

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Moss establish criteria for effectively demonstrating capture by defining the public interest in the

market in question, illustrating how policy has shifted away from that interest, and producing

evidence that the private interest actively steered the change in policy.19

Alternatively, capture can be viewed as a spectrum, with “cultural capture” reflecting the

degree to which the regulatory body internalizes the views or analysis conducted by the regulated

body as accurate and effective policy. The former calls for a more rational choice based

approach to regulatory failure, whereas the later points towards a behavioral analysis of the

various cognitive shortcomings that allow regulators to make crucial mistakes in their policy

evaluation. James Kwak lays the intellectual foundation for the idea of cultural capture in the

financial sector by establishing a clear framework for identifying and explaining how capture

permeated the financial industry and contributed to the lack of reform after the financial crisis of

2008. Kwak identifies three essential components: identity (in-group, out-group identification of

policy stakeholders), status (perception of private sector contributors to be of a higher intellectual

caliber than the regulatory body), and relationships (regulators are more likely to agree with

those in their networks).20

The works of Carpenter, Moss, and Kwak provide several key insights into the analysis of

capture. First, capture must be analyzed on a spectrum as opposed to a binary system of capture

versus no capture. Specific institutional designs may exacerbate the degree of capture that occurs

in a given industry and looking for those design aspects is highly salient. Second, capture may

not manifest itself through the advancement of specific material incentives of the regulator, but

rather through the amalgamation of the public and private interest as one and the same. This may

                                                                                                               19 Carpenter and Moss, Preventing Regulatory Capture: Special Interest Influence and How to Limit It, 1-22 and 451-66. 20 James Kwak, “Cultural Capture and the Financial Crisis.” In Preventing Regulatory Capture, ed. Daniel Carpenter and David Moss (Cambridge: Cambridge University Press, 2013).

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be aggravated where there are high levels of complexity in determining the public interest and

when industry participants are able to proffer a compelling argument as to why their interests and

the public’s may in fact be aligned. Lastly, they provide a strong burden of proof for both

cultural and regulatory capture.

The challenge with applying and considering regulatory capture as a potential explanation for

the lack of reform, though, is the absence of an agreed upon conception of the “public interest.”

Economists have engaged in a robust debate as to whether the current system of credit ratings is

in need of reform, and if so, how said reform should be structured. In the case of CRAs,

indicating that they improperly analyzed mortgage-backed securities during the financial crisis as

the sole evidence of capture would be insufficient. All regulation is subject to potential failure

and the public interest is not always agreed upon, especially in the case of complex financial

products.21 There is, however, empirical evidence to explore in terms of the degree to which

CRAs lobbied for their interests.

A second potential alternative is that CRAs held a “privileged position” in the regulatory

structure, leading regulators to fear that any policy changes would have negative effects on the

economy as the country emerged from the Enron scandal in 2001 and the financial crisis of 2008.

This analysis, championed by Charles Lindblom, critiques the embedded nature of market

participants and their central role in the economic health of the nation. Since some private actors

are crucial to the overall health of the economy, regulators are forced to ease on regulation out of

fear of potentially triggering unemployment or market constriction through higher levels of

regulatory oversight or policy change.22 Furthermore, entrenched private actors exaggerate the

                                                                                                               21 Kwak, “Cultural Capture and the Financial Crisis.” 22 Charles Lindblom. “The Markets as Prison.” The Journal of Politics, Vol. 44, No. 2, (1982). http://www.jstor.org/stable/2130588?seq=1#page_scan_tab_contents.

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threat of these “punishments” and attempt to portray the costs of increases in regulatory

oversight as dramatically detrimental to the economy, despite their potentially trivial effects.

This logic may have played a role in constricting the options for CRA reform. CRAs ideally

play a key role in the market economy by providing prospective investors with quality

information about the assets available in the market for investments. The implicit “punishment”

that these companies could present is that tampering with the ratings system would hurt the

economy. In fact, Jerome Fons of Moody’s, in a 2002 article on the role of CRAs, stated, “I

believe that regulators want to preserve the objectivity, and hence the accuracy, of ratings.

Inaccurate ratings will result in bank capital levels that could either put the payment system at

risk or lead to a misallocation of funds within the economy.”23 Thus, the possibility of regulation

harming the economy was a tool leveraged by CRAs. Another potential area of leverage that

CRAs have in relation to the U.S. federal government is the ability to downgrade U.S. debt.

Interestingly, S&P did in fact downgrade the value of U.S. debt from AAA to AA+ in August of

2011, around the time when rules and regulations were being established for CRAs after Dodd-

Frank.24 It is conceivable that CRAs utilized this role to punish the federal government through

the downgrade, though the decision only had symbolic ramifications on the value of U.S. debt.

CRAs arguably had a “privileged position” in the market for credit ratings that could have

been utilized to limit the scope of reform. The central challenge with adopting this hypothesis,

however, is that these potential punishments or threats are inherently hard to measure. CRAs

could justify their downgrade of the U.S. debt, for example, due to the debt ceiling fight that was

on-going at the time as opposed to any veiled threat against government oversight. Furthermore,

                                                                                                               23 Jerome S. Fons, “Policy Issues Facing Rating Agencies,” in Ratings, Rating Agencies and the Global Financial System, ed. Richard M. Levich, Giovanni Majnoni, and Carmen Reinhart. (New York: Kluwer Academic Publishers, 2012), 343. 24 Damien Paletta and Matt Phillips, “S&P Strips U.S. of Top Credit Rating,” The Wall Street Journal, August, 6 2011. http://www.wsj.com/articles/SB10001424053111903366504576490841235575386

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Lindblom argues that these threats often go unfulfilled and that the specter of potential action

limits the scope of reform. The impact of these implicit threats is a theoretical concept rather

than an easily observable phenomenon, restricting the ability to test this hypothesis in the

legislative debates surrounding both the Reform Act of 2006 and Dodd-Frank.

Lastly, it is also possible that federal regulators thought that this regulatory system was

simply the most efficient way to tackle a complex policy problem – even in light of the financial

crisis of 2008. At the time this decision was made in the 1930’s, federal regulators had several

strategies to fulfill their prudential regulatory role. First, they could rely on the financial

institutions to undertake positions that were safe and to maintain stable positions in the bond

market. Second, federal agencies could conduct internal tests to determine the safety and

soundness of banks under their purview. Third, prudential regulators could rely on third-party

actors to evaluate the soundness of these financial institutions. The first alternative, however,

could be viewed as a prima facie failure to follow through on regulatory responsibilities. If

financial institutions were completely left alone to evaluate the risk of their own investment

positions, prudential regulators would not be carrying out their statutory roles. Practically,

financial regulatory authorities faced two policy choices: internal or external risk analysis to

measure the safety of financial institutions.

First, cost-savings are one potential benefit of outsourcing credit evaluation to private

actors. Developing internal metrics for analyzing risk is ultimately a costly process. Thus,

establishing a principal-agent relationship with a specialized agent could be considered an

efficient solution – reducing the workload and informational challenges for the principal.25 If

third party actors were incentivized to provide this private service that in turn helped stabilize the

                                                                                                               25 Andreas Kruck, Private Ratings, Public Regulations: Credit Rating Agencies and Global Financial Governance (London, Palgrave MacMillan, 2011), 85.

  20  

financial system, federal authorities only had to adequately incentivize the use of this third party

service. The benefit described above is further strengthened if financial markets are relatively

stable. Such was the case in the 1930s, as postwar bond market stability lessened concerns about

possible issues in the financial markets, effectively reducing the cost of relying on a third party

to provide this service.26 Complimentary to favorable market conditions after the crash of 1929,

the National Bureau of Economic Research’s statistics on bond markets during the 1930’s, 40’s,

50’, and 60’s demonstrated that CRAs were generally measuring risk accurately and consistently

with market trends.27 Furthermore, the default rates on bonds were incredibly low, and as such,

the information promulgated by CRAs was not a large market force.28

There are, however, serious potential costs involved with this delegation. First, federal

regulators left themselves vulnerable to financial distress if CRAs failed to adequately assess

risk. Ultimately, if banks were overly leveraged in risky bond investments, and CRAs were

unable to evaluate those positions as such, the federal government would be responsible for

dealing with the macroeconomic fallout. This cost, however, is minimized if federal regulators

believe that 1) the probability of CRA error is low and 2) the eventual cost from this

misinterpretation would be minimal.

Both capture arguments and discussions about the structural role of private actors in the

market economy offer important lenses through which to view the question of interest – but fail

to be easily operationalized in the context of this paper. Though capture theoretically covers the

mechanism through which regulators fail to enact effective oversight, defining the public good in

                                                                                                               26 Richard  Sylla,  “A  Historical  Primer  on  the  Business  of  Credit  Ratings.”  10. 27 Braddock Hickman, “Introduction and Summary of Findings to ‘Corporate Bond Quality and Investor Experience,” in Corporate Bond Quality and Investor Experience (New Jersey, Princeton University Press, 1958), 3-27. 28 Braddock Hickman, “Introduction and Summary of Findings to ‘Corporate Bond Quality and Investor Experience,” 3-27.

  21  

financial markets is a significant challenge. Furthermore, understanding the interpersonal

relationships between regulators and CRAs is nearly impossible without higher levels of direct

access to market participants. While understanding the unique role of CRAs in the current

government structure and the potential “privileged position” that these actors hold in the market

economy is also important, it often relies on implicit and veiled threats which are impossible to

observe in the evidence. Lastly, the experience of the financial crisis of 2008 calls into question

whether regulatory outsourcing is in fact the most efficient system of oversight. Both politically

and analytically, ignoring the massive failure of CRAs during the Enron scandal and the

financial crisis of 2008 illuminated the high costs of this regulatory system. It is important to

note that both of the theoretical models of capture and privileged positions can coexist with my

hypothesis and path dependence model. The central goal of this paper, though, is to understand

which process provides the highest level of explanatory power in terms of understanding the

regulatory outcome.

  22  

Chapter III: Evidence

A) Evaluating Qualitative Evidence

A variety of tools exist in the social sciences to assess the strength and utility of

qualitative data for the purpose of teasing out causal arguments. For the purpose of this thesis, I

will be relying on “process tracing” as discussed by David Collier to assess the degree to which

the evidence I present can be connected to the causal argument of path dependence and the

binding constraints it produced on policymaking after the financial crisis of 2008.

Process tracing “is an analytical tool for drawing descriptive and causal inferences from

diagnostic pieces of evidence – often understood as part of a temporal sequence of events or

phenomena.”29 Under Collier’s approach to process tracing, the researcher must identify

diagnostic evidence: evidence that helps develop the foundation upon which causal inferences

will be built. Second, descriptive inferences can stem from the diagnostic evidence, evaluating

how that diagnostic evidence builds over time through precise explanations of static moments of

significance that contribute to the development of a longitudinal process. Thus, process tracing

focuses on the sequence of events within a case that build together to form causal arguments.30

For the purposes of this paper, the “case” in question is the sequence of events that lead to the

lack of reform for CRAs after the financial crisis of 2008.

Collier utilizes these components to build several tests that can be generated to analyze

potential causal inferences. First, straw in the wind tests allows the researcher to confirm the

relevance of their hypothesis in relation to the inferences in question. Thus, evidence in this

                                                                                                               29 David Collier, ‘‘Understanding Process Tracing.’’  PS: Political Science and Politics 44:823-30, (2011). http://polisci.berkeley.edu/sites/default/files/people/u3827/Understanding%20Process%20Tracing.pdf. 30 Andrew Bennett and Jeffrey T. Checkel, “Process Tracing: From Philosophical Roots to Best Practices,” in Process Tracing in the Social Sciences: From Metaphor to Analytic Tool, ed. Andrew Bennett and Jeffrey Checkel, (Cambridge University Press, 2012), 1.  

  23  

category is neither necessary nor sufficient, but provide basic facts and concepts that support the

hypothesis. Second, hoop tests provide clear benchmarks that the hypothesis must meet to

remain viable. Evidence in this category is necessary for the hypothesis to stand, but is not

sufficient for understanding the causal process. Third, smoking gun tests provides strong support

for a hypothesis without giving evidence to reject other competing theories. Evidence in this

category is not necessary for the hypothesis to stand, but provide strong support for the

sufficiency of the proposed solution. Fourth, double decisive tests produce the highest standards,

both confirming the argument posed and rejecting competing hypotheses for a given

phenomenon. These pieces of evidence point towards the hypothesis being both necessary and

sufficient. I will utilize these tests at the conclusion of both critical historical junctures to

evaluate the strength of the evidence presented in supporting my argument and potentially

disproving the alternatives. For the purposes of this paper, I will not be able to prove that capture

or the embedded position of CRAs had zero impact on the regulatory process. I will instead seek

to demonstrate the necessary and sufficient nature of the evidence supporting the impact of the

historical junctures on the regulatory outcome, giving weight to the argument that the historical

factors were the chief explanatory variable of the lack of effective reform.

B) Creating Regulatory Dependence: 1930-1975

From 1930-1975, the federal regulatory framework for financial institutions grew dependent

on CRAs to evaluate the riskiness of assets, and thus the safety and soundness of financial

institutions. This produces the first critical juncture where regulatory outsourcing and

dependence is established. When presented with the policy challenge of evaluating the stability

of financial institutions, federal regulators made the crucial decision, among multiple choices, to

rely on the analysis conducted by CRAs.. During this period, the initial development of the lack

  24  

of internal expertise and the spread of regulatory outsourcing across multiple sectors is observed.

First, the regulatory role of evaluating credit risk was outsourced to CRAs and the private sector

– with explicit discussion by regulators that this role would be carried out only in the private

sector. Second, once regulatory outsourcing was codified at the federal level, it spread

throughout numerous policy spheres. Thus, this critical juncture establishes the baseline

consequences of regulatory outsourcing that eventually shaped the next historical juncture and

contributed to limiting the scope of reform in 2006 and 2010.

First, it is important to describe some of the key themes in the financial markets at the time.

The Crash of 1929 and the onset of the Great Depression provided the first financial setting that

demonstrated the fragility of bond ratings issued by CRAs. During the period, numerous ratings

were scaled back as a variety of bonds that were considered safe defaulted.31 The paradox in this

development was that despite the lack of success by CRAs to predict risk, the overall higher risk

environment generated elevated demand for assurances of asset quality. The Great Depression

went on to cause massive economic hardship, with bank failures spiking to 12.9% of total banks

in 1933. This economic harm was compounded by the lack of a deposit insurance system.32 At

the time, CRAs operated exclusively in the private sector with no government supervision. The

market was also controlled by S&P, Moody’s, and Fitch, the same firms that hold the lions share

of the market today.

a. Regulatory Outsourcing and the Lack of Internal Expertise

In 1931, the United States Department of the Treasury through the OCC codified the first

                                                                                                               31 Frank Partnoy, The Paradox of Credit Ratings,” University of San Diego Law & Economics Research Paper No. 20, (2001). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=285162. 32 Ben Bernanke, “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression.” National Bureau of Economic Research, No. 1054, (1983).  http://www.nber.org/papers/w1054.pdf.

  25  

systemic regulatory dependence on CRAs by making it essentially more expensive for banks to

hold bonds that had lower than a BBB rating, as defined by CRAs.33 As stated in the Wall Street

Journal on September 12, 1931, “it was asserted that state, municipal, and government bonds and

issues given the four highest ratings by statistical corporations did not have their intrinsic value

impaired by market fluctuations.”34 The Wall Street Journal echoed a commonly shared

sentiment: the ratings given by statistical organizations were an effective indicator of the stability

of assets and that relying on them to carry out this role would be prudent public policy.

In 1936, the OCC furthered the push towards regulatory dependence on CRAs. On February

15th, the OCC stated that the “purchase of ‘investment securities’ in which the investment

characteristics are distinctly predominantly speculative… is prohibited. *

*The terms employed herein may be found in recognized rating manuals…*”35 The OCC thus

bestowed a strong incentive for financial institutions to hold “investment grade” bonds, as

determined by CRAs. If a bond portfolio was found to be “investment grade,” than the financial

institution would be able to value the portfolio at the purchase cost, whereas portfolio’s graded

lower than investment quality would have to be “marked to market” and more closely

evaluated.36 Investment grade was to be measured by “recognized rating manuals” which, in

practice, referred to the primary players in the market: Fitch, Moody’s, and S&P.37 This

development is striking: not only did the federal government entrust CRAs with the responsibility

of accurately measuring risk in the financial markets, they built a system in which regulatory

                                                                                                               33 Gilbert Harold, Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness (New York, Ronald Press,1938), 25. 34 Wall Street Journal, September 12, 1931, at 1.  35 Regulations governing the Purchase of Investment Securities, and Further Defining the Term “Investment Securities” as Used in Section 5136 of the Revised Statutes as Amended by the “Banking Act of 1935,” Sec. II, issued by the United States Comptroller of the Currency, Washington, February 15, 1936). 36 Lawrence J. White “Credit Rating Agencies: An Overview,” Annual Review of Financial Economics, Vol. 5. (2013). 37 White, “Credit Rating Agencies: An Overview.”

  26  

effectiveness was contingent on the CRAs existence, with limited to no supervision. Additionally,

the federal government provided a customer base to CRAs by establishing the expectation that

banks must pay attention to the information produced by these agencies.38 Lastly, it is important

to note that the OCC decisions applied to all national banks.

In 1936, the Missouri Banker’s Association raised a resounding critique of the OCC’s

decision: “We further believe that the delegation to these private rating agencies of the judgment

as to what constitutes a sound investment is unprecedented in our history and wholly

unwarranted by their records in the past.”39 The Association, citing the inability of CRAs to

effectively measure risk during the Great Depression, rebuked the government’s dependence on

these institutions. This challenge came in sharp contrast to the initial assessment by the Wall

Street Journal in 1931: “Comptroller Pole pointed out that he had discussed the policy which his

office had adopted with Treasury officials and prominent bankers throughout the country, all of

whom agreed that it was sound and within the public interest.”40 Weeks after the association

raised their concern, the OCC immediately stepped back from their strong stance, stating “the

responsibility for proper investment of bank funds, now, as in the past, rests with the Directors of

the intuition, and there has been and is no intention on the part of this office to delegate this

responsibility to the rating services.”41 O’Conner went on to state “reference to the rating

manuals was made… in recognition of the fact that many banking institutions, by reason of lack

of experienced personnel and access to original sources, are unable personally to investigate the

background, history and prospects of a particular issuer of securities, and consequently must rely

                                                                                                               38 White, “Credit Rating Agencies: An Overview.” 39 Resolution of the Missouri Bankers Association at its 46th annual convention, Kansas City, Mo., May 5, 1936.  40 Wall Street Journal, September 12, 1931, at 1. 41 J.F.T. O’Connor, Comptroller of the Currency, Address at a convention of the California Bankers Association, Sacramento, Cal., May 22, 1936.

  27  

to some extent upon such information as has been compiled by various rating services in their

large rating manuals...”42

Analyzing the discourse at the time, it is clear that regulatory authorities sought a limited

to non-existent role in assessing the safety of assets. Based on O’Connor’s statements in 1936,

the OCC was far from ready to play a prominent role in forcing banks to be subject to the

analysis of CRAs, let alone scrutiny by federal regulators. Furthermore, banks viewed the

allocation of regulatory discretion to private CRAs as a removal of banker autonomy, arguing

that such an allocation was an unprecedented decision to allocate regulatory responsibility to a

private actor.43 Braddock Hickman’s account of the decision to outsource credit rating

responsibilities further establishes the contentious nature of the debate and eventually resulted in

the reference to “recognized rating manuals” being removed from the regulations in 1938.44

Nevertheless, federal regulators had established the benefits of “investment grade” bonds without

answering the residual question of who would deem them such.

This marks the beginning of the lack of internal expertise for evaluating credit risk.

Furthermore, the public and private sector’s belief in a limited governmental role in the market

for asset information is clearly discussed. Based on public statements proffered by the OCC, it is

clear that they had no intention of stepping into the private sector and evaluating the riskiness of

assets. Whether that role was allocated to CRAs or the banks themselves, the federal government

had zero interest in operating in these sphere– establishing the foundation for a lack of internal

expertise within the federal government to carry out effective risk analysis. Furthermore, this

may help explain the eventual hesitancy of federal regulators to take on a larger role after Enron

                                                                                                               42 O’Conner, “Address to California Bankers Association.” 43 Braddock Hickman, “Front Matter, Statistical Measures of Corporate Bond Financing Since 1900,” in Statistical Measures of Corporate Bond Financing Since 1900, ed. W. Braddock Hickman and Elizabeth T. Simpson (New Jersey, Princeton University Press, 1960). http://www.nber.org/chapters/c2463.pdf. 44 White, “Credit Rating Agencies: An Overview.”

  28  

and the financial crisis of 2008. The OCC’s decision to stay out of the way of financial

institutions and the operations of CRAs set precedent that will be further enforced in the next

historical juncture.

C) Regulatory Outsourcing Throughout Multiple Policy Spheres

Though the regulatory decision to empower CRAs to evaluate the safeness of assets on

the market was rolled back by the OCC seven years after initiation – the impact was swift and

widely felt. Overnight, the OCC had effectively slashed in half the bonds that were viable

investments for banks.45 Furthermore, allocating regulatory policy responsibilities to CRAs had

immediate effects on the prudential regulation of other areas of financial activity. When state

regulators were faced with similar regulatory challenges – they followed suit. Frank H. Johnson,

Superintendent of Banks for Montana, stated “we depend upon the ratings for our guidance,

assuming that they are reliable and honest.”46 Statements of a similar nature by Bank

Superintendents of Mississippi, Alabama, and Oregon can be found – analysis provided by

CRAs were “a fair valuation,” “very helpful,” and “generally accepted.”47 State regulators also

adopted this system to evaluate life insurance providers and the capital they needed to keep in

safe investments. Between 1936-1974, 48 state regulators folded CRAs into their regulatory

practices, establishing minimum capital requirements for banks that corresponded to the riskiness

of the bonds held in their portfolios, with risk being measured by CRA ratings.48 Additionally, in

                                                                                                               45 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 31. 46 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 27. 47 Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 28. 48 Lawrence J. White, “Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response.” Journal of International Banking Law and Regulation.  

  29  

1951, the National Association of Insurance Commissioners instituted higher capital

requirements on insurers, as measured by the ratings produced by CRAs.49

Table 1: Federal Regulatory Dependence on CRAs50

It is important to note that every additional inclusion of CRAs in the regulatory process

increased the cost of designing an alternative regulatory system. CRA dependence spread to the

state level and to insurance markets as the go-to source for credit risk analysis, developing entire

regulatory systems around this dependence. Emerging from the Great Depression, the evidence

indicates that regulatory bodies at the state and federal level were looking for mechanisms to

better oversee the financial system. CRAs provided a quick and potentially easy solution to this

challenge by ensuring that financial institutions would only hold “safe” assets. This logic

permeated a host of regulatory spheres, imbedding this principle in multiple areas of policy at the

state and federal level and further entrenching this policy design. This initial spread established

                                                                                                               49 Timothy Sinclair, The New Masters of Capita: American Bond Rating Agencies and the Politics of Creditworthiness (New York, Cornell University Press, 2008), 43. 50 Sinclair, “New Masters of Capital,” 43.  

  30  

the foundation for future reliance on CRAs in other policy sectors that eventually limited the

scope of potential reform by increasing the cost of alternative policy designs in 2006 and 2010.

Furthermore, writers and economists at the time recognized the growing strength of

CRAs and the role of government policy in establishing that strength. According to Gilbert

Harold’s landmark book on the subject in 1938, “it is unanimously asserted by the rating

agencies that the use of bond ratings today is greater than ever before and that the use of and

reliance on the ratings is growing year by year.”51 Furthermore, Harold stated that,

“governmental supervisory commissions, the office of the Comptroller of the Currency, and the

Federal Reserve banks employ bond ratings in examining the portfolios of banks under their

jurisdiction. Indeed their use in this connection by bank (and insurance) commissions of most of

the states as well as by the federal government is perhaps the most important assignment which

the ratings have been given.”52 According to writers at the time, government recognition of

CRAs through federal policy at the time was the single most important factor in solidifying their

role in the market economy.

D) Conclusion

The first historical juncture matches the criteria identified by Pierson as indicative of

increasing returns. First, there were multiple potential equilibriums in 1936 when the federal

government decided to rely on credit rating agencies. Alternatively, they could have developed

internal metrics for credit analysis but instead opted to outsource this task to CRAs or to bank’s

to conduct internally. Second, the small and seemingly inconsequential decision to rely on

“recognized rating manuals” set the tone for how other regulators would look to evaluate the

                                                                                                               51  Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 34.  52  Harold, “Bond Ratings as an Investment Guide: An Appraisal of Their Effectiveness,” 212.  

  31  

riskiness of financial assets. Whether federal regulators recognized it or not, every financial

regulatory body was determining a method for evaluating the safeness of assets, and the decision

to be a first-mover in allocating this responsibility to CRAs was of immense consequence.

Additionally, timing is crucial, as the decision to outsource this responsibility came as the

country was emerging from the Great Depression and trying to develop systemic ways to limit

financial risk. Lastly, the policy choice to allocate risk-assessment to CRAs begins in this period

and sets the stage for future growth in the policy design during the second critical juncture.

In this section, methodologically, I have been able to produce straw in the wind

arguments on behalf of the initial hypothesis. Though the quick succession of identical

regulatory structures that outsourced credit evaluation to CRAs is striking, it only supports that

argument that these decisions illustrate a lack of internal expertise within federal regulatory

agencies during the time period in addition to preliminary regulatory outsourcing across multiple

policy arenas. This historical juncture neither rejects alternative hypothesis nor gives clear

barriers that the hypothesis must overcome, but nevertheless provides basic foundational

evidence to support the argument for a path dependence model. Similarly, this fact pattern is

neither necessary nor sufficient to prove my hypothesis that the historical regulatory outsourcing

limited the scope of potential reform in 2006 and 2010. This foundational set of facts provides

the bedrock of the argument that future policy developments were developed in the context of

this initial codification of regulatory dependence. Further evidence will either confirm or deny

that this initial policy decision played an important role in future decisions pertaining to CRAs in

the regulatory process.

  32  

III) Legitimizing Regulatory Dependence: 1975-1985

In 1975, the SEC took the next step in codifying the regulatory role of CRAs through the

creation of NRSROs. This produces the second critical juncture where dependence on CRAs was

legitimized and strengthened. When the SEC faced the regulatory challenge of analyzing the

safety of the bond portfolios held by broker dealers, they relied on a similar outsourcing process

as other prudential regulators and took that process a step further through the codification of

NRSROs. This historical period also demonstrates clear signs of a lack of internal expertise to

evaluate the safety of assets at the federal level in addition to evidence that regulatory

outsourcing to CRAs was continuing to spread. In this section, both the causes of the regulatory

decision to further entrench CRAs and the consequences of that decision are important in both

illustrating the continuity of the path dependence model and establishing the binding effects that

this juncture had on the scope of potential reform in 2006 and 2010.

Just as previous regulatory decisions to allocate responsibilities to CRAs came at the end of

financial uncertainty (The Great Depression, bank failures of the late 1920’s), New York City’s

brush with financial hardship also sent ripple effects throughout the regulatory community. In

1975, New York City was essentially out of funds after continuing to maintain a robust social

welfare system in the context of dramatically declining revenues.53 During the same time period,

CRAs completely failed to adjust the city’s debt ratings. At the onset of the financial collapse,

New York’s debt was still rated an A despite fundamental problems in the city’s ability to pay

back the debt it had accumulated.54 Though the state and federal government stepped in and

eased the transition, the threat of default for one of the most prominent cities in the country, and

the inability of CRAs to inform investors of this possibility, was highly alarming to the SEC. In

                                                                                                               53 Roger Dunstan. “Overview of New York City’s Fiscal Crisis.” California Research Bureau, California State Library, Vol. 3, No. 1, (1995). 54 Dunstan, “Overview of New York City’s Fiscal Crisis.”

  33  

an exhaustive report published in August of 1977, the SEC voiced their discontent with the

quality of the analysis conducted by CRAs: “Based upon the record of this investigation, it

appears that both Moody’s and S&P failed, in a number of respects, to make either diligent

inquiry into data which called for further investigation, or to adjust their ratings of the City’s

securities based on known data in a manner consistent with standards upon which prior ratings

had been based.”55

A) Regulatory Outsourcing and the Lack of Internal Expertise

First, it is important to note whether recent economic events had shifted the conversation for

the OCC and other federal regulators regarding the role and prominence of CRAs in the

regulatory process. During a 1967 Senate hearing in the Subcommittee on Financial Institutions;

Committee on Banking and Currency, the OCC maintained their deference to CRAs as the only

legitimate actors for the analysis of financial instruments. When asked how many analysts he had

on hand to assess the risk of portfolios owned by institutions, William Camp, head of the OCC,

stated: “Well, there are a number of rating services throughout the country, Standard & Poor’s,

Moody’s, any number of them.”56 This aligns with previous statements by the head of the OCC

that CRAs were the best equipped to evaluate asset risk and the soundness of bonds. When asked

how many analysts the OCC had on staff to conduct the kind of analysis produced by CRAs,

Camp stated, “I would say at least 10 people…”57 Thus, the head of the principle regulatory body

charged with potentially overseeing CRAs felt that these institutions were fully capable of

                                                                                                               55 U.S. House. Committee on Banking, Finance, and Urban Affairs. Securities and Exchange Commission Staff Report on Transactions in Securities of the City of New York, 1997. https://www.sec.gov/info/municipal/staffreport0877.pdf 56 U.S. Senate. Subcommittee on Financial Institutions; Committee on Banking and Currency. “Bank Underwriting of Revenue Bonds.” August 28-30, September 12, 1967. Available from: ProQuest Congressional Search. HRG-1967-BCS-0027. 57 HRG-1967-BCS-0027.

  34  

replacing federal regulators in measuring the safeness of the investments held by financial

institutions, maintaining consistency with previous statements by the OCC in the 1930’s.

The SEC, however, seemed more critical of the now prominent role of CRAs. In a “Report of

Special Study of Securities Markets” to the House Committee on Interstate and Foreign

Commerce in 1963, the SEC noted: “Analyst’s research which is limited to the data set forth in

the services may be superficial since the services’ data are not necessarily complete.”58

Furthermore, the report discussed the failure of CRAs in analyzing Atlantic Research Corp.,

detailing how CRAs inflated ratings dramatically above what the SEC’s own analysis indicated.

In contrast to the OCC’s capacity to complete this kind of analysis, SEC researchers noted that

“Standard & Poor’s had the largest research staff, consisting of 27 analysts, 12 assistant analysts,

15 field representatives, and 8 statisticians.”59 Despite the SEC’s concerns and findings, only 10

OCC staff members, with no experience or special training in the field, were tasked with

understanding and assessing the deals and analysis conducted by all of the CRAs in the market.

This demonstrates that federal regulators lacked the capacity, funding, and skillset necessary to

conduct risk analysis on par with CRAs. The OCC’s previous decisions to rely on CRAs for risk

analysis was directly showcased by the absence of staff dedicated to the task of evaluating

CRAs.

During this period, the SEC was considering the “net capital rule” for broker dealers that

would establish looser capital restrictions for institutions that held investment grade bonds. The

rule was eventually established in 1975.60 Similar to the OCC, the SEC had to design a system

for evaluating what bonds would be considered “investment grade” and how best to determine

                                                                                                               58 U.S. House. Committee on Interstate and Foreign Commerce. “Special Study of Securities Markets, Pt. 1.” April 3, 1963. Available from: ProQuest Congressional Search. 12576 H.doc.95.  59 12576 H.doc.95 60 See 17 CFR 240.15c3-1 – Net Capital Requirements for Brokers or Dealers.

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the stability of assets. Again, the SEC had three policy alternatives: evaluate the safeness of

assets internally, allow the banks to conduct this analysis themselves, or rely on CRAs to fulfill

this function. In November of 1977, the SEC seemed to view CRAs more favorably in

comparison to their previously critical report in 1963, stating in their November address,

“corporate security ratings are considered useful by many members of the investment community

and that currently such ratings are widespread in the securities markets and frequently are relied

on in investment and other processes.”61 It is hard to determine what happened in the 14 years

between the SEC’s investigation of Atlantic Research Corp. and the 1977 statement by the SEC,

but it is clear that the SEC’s views on CRAs dramatically shifted.

The SEC, however, was concerned with putting the trust of federal regulatory policy in the

hands of any institution that claimed to be a CRA. Instead, they opted to create NRSROs:

officially recognized CRAs that would be statutorily enabled to analyze asset risk for the purpose

of SEC regulations. The designation of NRSROs was a crucial decision: it established that there

would only be a few select CRAs that the government would entrust, producing a barrier to entry

for other CRAs in the market. The top three firms, Moody’s, S&P, and Fitch, were all

grandfathered in as NRSROs.62 The rational behind this codification was paradoxical: because

CRAs already played a crucial role in the regulatory process, their role should be further

solidified so as to ensure some level of quality control. This gives further credence towards the

path dependence model in that the decision to further enmesh CRAs into regulatory policy

stemmed in part from their already embedded role in the sector.

With the creation of NRSRO’s, prudential regulators would now rely on the ratings produced

by selected CRAs when evaluating capital requirements and the safety of assets held by

                                                                                                               61 Paul Dykstra. “Disclosure of Security Ratings in SEC Filings.” 78 Det. C.L. Rev. 545 (1978). 62 Emily Ekins and Mark Calabria, “Regulation, Market Structure, and Role of the Credit Rating Agencies.” Policy Analysis, No. 704, (2012).

  36  

institutions under their purview. For the SEC, this was codified in 17 CFR 240.15c3-1 which

established that commercial paper, nonconvertible debt securities, and convertible debt securities

would all be scrutinized based on the ratings established by the NRSRO’s. If a security received

“one of the four highest ratings by at least two of the nationally recognized statistical rating

organizations…” than less collateral would be permissible.63 Importantly, these rules did not

mandate that the SEC play any role in overseeing the methodology of CRAs or the functioning

of their operations.

Furthermore, no clear application process or methodology for becoming a NRSRO was

created. For a firm to gain NRSRO status, they would have to send in an application and wait for

a response at the convenience of the SEC. If granted, the firm would “receive a 'no action’ letter

from the staff; the letter promised that the Division of Market Regulation would not recommend

enforcement action against any broker-dealer that used the applicant’s ratings for determining its

capital requirements. The SEC did not even issue a press release at these times (and additionally

insisted in the no-action letter that the applicant not market itself as an NRSRO).”64 Given that

there was no clear rational or methodology for choosing NRSROs, let alone critiquing their

analytical process for evaluating the safeness of assets, the SEC had a limited to non-existent role

in evaluating credit risk or supervising the practices of NRSROs. This strengthens the argument

that the SEC did not have the skillset or experience necessary to play a large role in this

regulatory sphere.

The evidence seems to indicate that neither the OCC nor SEC had the desire or capacity to

evaluate credit risk. First, the OCC explicitly stated in testimony to the Senate that they relied on

CRAs to effectively evaluate credit risk. This was entirely consistent with previous statements by

                                                                                                               63 See 17 CFR 240.15c3-1 – Net Capital Requirements for Brokers or Dealers. 64 Lawrence White. “A New Law for the Bond Rating Industry.” Regulation, (2007).

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the OCC indicating a deep hesitancy to get involved in supervising CRAs or the investment

practices of financial institutions. While the SEC was initially more critical of CRAs, they also

conceded that CRAs were the best staffed and prepared to carry out risk analysis in the market,

and in this analysis of the rule-making and legislative record, never suggested that they should be

involved in carrying out this work internally. Furthermore, the SEC did not establish a role in

overseeing the evaluation process of CRAs. Thus, there is evidence to suggest that there was no

internal expertise or mechanisms to carry out the role that CRAs were playing in the market,

despite examples of their failure to do so throughout the time-period.

B) Regulatory Outsourcing Throughout Multiple Policy Spheres

The creation of NRSROs had a huge impact on the proliferation of systemic dependence on

CRAs that eventually constrained decision-making in 2006 and 2010. After the SEC decision to

create NRSROs, codified dependence on CRAs spread to a multitude of policy sectors at the

federal and state level. This proliferation increased the entrenched nature of regulatory

dependence on CRAs, and thus the cost of potential alternative systems of regulation.

Additionally, the creation of NRSROs was inherently shaped by previous regulatory decisions in

that the policy design mimicked previous dependence on CRAs by the OCC. Thought it is

possible that this design was conceived completely independently, it is hard to imagine that the

SEC did not consider the OCC’s strategy for risk assessment when developing the Net Capital

Rules. In 1994, the SEC went on to state: “the utilization of NRSRO ratings, therefore, is an

important component of the Commission’s regulatory program.”65

                                                                                                               65 Securities and Exchange Commission. “Concept Release: Nationally Recognized Statistical Rating Organizations.” Release Nos. 33-7085; 34-34616; IC-20508. August 31, 1994. http://www.sec.gov/rules/concept/34-34616.pdf  

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In a January 2003 Report by the SEC on the role of CRAs in securities markets, the

proliferation of regulatory dependence on CRAs after the creation of NRSROs was documented

at length. First, the SEC had included NRSROs into regulations and rules connected to the

Securities Act of 1933, The Exchange Act, and the Investment Company Act of 1940,

influencing rules and regulations regarding money market funds, non-convertible debt, preferred

securities, and asset-backed securities.66 Congress also participated in this proliferation,

incorporating NRSROs into the Secondary Mortgage Market Enhancement Act of 1984 and

amendments to the 1950 Federal Deposit Insurance Act.

At the state level, the trend of regulatory dependence continued at a breakneck pace. For

example, California Insurance Code in 2003 relied on NRSRO ratings in regards to the

investments that incorporated insurers could make.67 Texas and New Jersey insurance codes

featured similar levels of dependence, mandating that insurance providers only invest extra funds

in assets given high levels of safety by NRSROs. An analysis conducted by Emily McClintock

Ekins and Mark A. Calabria found that by June of 2005, “8 federal statutes, 47 federal rules, and

100 state laws referenced credit ratings issued by NRSRO CRAs.68 The following table

combines their analysis with a list of regulations compiled by Timothy Sinclair to provide a

robust list of federal laws that built CRAs into the regulatory process. Combined with the

widespread dependence created in state law, this historical juncture witnessed an immense

increase in statutory inclusion of CRAs.

As will be further described in the next chapter, the proliferation of regulatory inclusion

of CRAs limited the scope of potential reform by increasing the complexity and cost of

                                                                                                               66 Securities and Exchange Commission. “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Market As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002.” (2003). 67 See California Insurance Code § 1192.10 (2003). 68 Ekins and Calabria, “Regulation, Market Structure, and Role of the Credit Rating Agencies.”  

  39  

switching to a larger regulatory role for the federal government. When faced with the failure of

the current regulatory system, the daunting economic task of unwinding years of regulatory

policy limited the scope of potential reform and biased the regulatory outcome towards

maintaining the status quo.

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Table 2: Federal Rules Referring to NRSROs 69

                                                                                                               69 Regulations aggregated from Ekins and Calabria, “Regulations, Market Structure, and the Role of Credit Rating Agencies,” and Sinclair, “New Masters of Capital,” 43.

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C) Conclusion

This critical juncture further illustrates the path dependence model through the lack of

internal expertise and the growth in dependence on CRAs throughout multiple policy spheres.

The SEC’s decision to create NRSROs further entrenched CRAs into the regulatory framework

and resulted in a mass proliferation of dependence in other regulations throughout the financial

system. Furthermore, testimony and research by the OCC and SEC confirm that both actors,

based on the evidence available, still viewed CRAs as the most capable to evaluate the riskiness

of market assets.

Again, we must reevaluate this development through the increasing returns model. Through

this critical juncture, we find that the equilibrium presented in the first critical juncture not only

persisted, but also seems to gain higher levels of inertia. From 1975-2001, several new areas of

financial products were folded under the outsourced regulatory authority of CRAs. Additionally,

the SEC formalized the role of CRAs at the risk of having unchecked organizations so heavily

involved in prudential regulation. Thus, the decision to codify the role of CRAs was driven by

their already entrenched role in the regulatory process. Faced with high switching costs, the

SEC maintained and expanded the regulatory structure around CRAs, further entrenching these

institutions in the regulatory process.

Furthermore, this juncture produces stronger evidence towards a path dependence model.

The decision by the SEC to build on the previous regulatory model arguably forms a hoop test or

potentially a smoking gun test. If the historical regulatory structure did not influence SEC

decision-making, it is difficult to explain how they arrived at an essentially identical structure of

regulatory outsourcing as the OCC developed in the 1930s. Though the system was different

with the implementation of NRSROs, it would be hard to argue that this system was derived

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independently of the historical context, and the high level of alignment provides strong evidence

towards a path dependence model. The clear parallels between the regulatory system developed

by the OCC in the 1930s and the NRSRO model developed by the SEC in the 1970s are

necessary pieces of evidence in supporting my hypothesis of a path dependence model that

restricted future regulatory decisions and are strongly sufficient in demonstrating that regulatory

policy in the 1930s helped shape policy decisions in the 1970s.

This body of evidence also forms straw in the wind arguments on behalf of the initial

hypothesis. Despite evidence in of the repeated shortcomings of CRAs, the historical equilibrium

built on previous policy decisions held. These factors support my hypothesis that a path

dependence model that began in the 1930’s eventually shaped the legislative outcomes in 2006

and 2010. If federal regulators were not constrained by the lack of skills for credit analysis at the

federal level and the imbedded nature of CRAs, the SEC and OCC would arguably have created

a new regulatory system in light of the many demonstrated failures by CRAs. The previous

sequence of regulatory allocation, however, proved binding to future policy decisions, creating a

continued path dependent process.

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Chapter IV: The Failure of Reform

A) Introduction

In this section, I seek to illustrate how the path dependence model, anchored by the two

historical junctures described previously, limited the scope of potential reform in both the

Reform Act of 2006 and Dodd-Frank. The evidence will show that the scope of these reforms

was limited by the lack of internal expertise by federal regulators and the mass proliferation of

regulatory dependence that generated high levels of inertia. The lack of internal expertise lead to

both private and public actors expressing clear doubts about whether the federal government

could take on a more expansive regulatory role. The increased cost of unwinding CRAs from the

regulatory process will be discussed throughout the legislative record in terms of the cost and

complexity of undoing dependence on CRAs. Both of these mechanisms are apparent throughout

the legislative and rule-making debate surrounding the role of CRAs in financial regulation. The

evidence will support my hypothesis that historical dependence on CRAs played a primary role

in shaping the regulatory outcome, though does not directly disprove alternative explanations

that CRAs or Wall Street had captured federal regulators. Furthermore, Lindblom’s argument

that CRAs potentially held a privileged position also finds some support in the legislative record.

In this section, I seek to understand the causes of the regulatory outcome and to assess the degree

to which they are grounded and connected to the path dependence model outlined previously. To

illustrate these points, I will utilize Congressional testimony and debates to assess the thought

process and rational behind the eventual laws passed in 2006 and 2010.

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B) 2006 Credit Rating Agency Reform Act

a. Background

Before evaluating the law, it is important to note a few important trends in the financial

sector and the structure of the credit rating business. In the period between 1985-2006, financial

markets grew in size and complexity, drastically increasing the potential risk of regulatory

outsourcing to CRAs. CRAs became responsible for evaluating highly complex assets – gaining

technical expertise and further increasing regulatory switching costs. Also, during this time

period, CRAs came under increasing scrutiny as the NRSRO process reduced competition in the

field and gave rise to concerns that an arbitrary oligopoly had been forming through codified

regulatory outsourcing. This development raised widespread critiques of maintaining the current

regulatory framework. Nevertheless, the equilibrium system of regulatory dependence held,

continuing the path dependence model.

First, financial markets underwent substantial legislative changes during the period in

question. Under the Carter administration, the Depository Institutions Deregulation and

Monetary Control Act slowly abolished limits on interest rates and incentivized greater

investment in insurance markets. Second, the Reagan administration’s passage of the Garn-St.

Germaine Depository Institutions Act eased limits on real estate and borrower lending,

contributing significantly to the weakness of mortgage loans that defaulted during the crisis of

2008. Under the Clinton administration, the Gramm-Leach-Bliley Act allowed previously illegal

banking conglomerates that combined insurance, investment, and deposit holding practices.

Furthermore, the whole period featured high levels of consolidation as rules barring the

combination of banks across state lines under the Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 were slowly overturned. In 1992, SEC Commissioner Richard Roberts

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noted, “…Rating agencies, despite their importance and influence, remained the only participants

in the securities markets without any real regulation.”70

Second, CRAs fundamentally shifted their business model during this period to an issuer pay

system of revenue generation. Under the original investor pay model, an investor seeking

information on the credit-worthiness of an asset or borrower would purchase the information

collected by the credit rating organization or pay a subscription fee to gain access. The issuer pay

model features companies looking to issue a security, bond, or debt instrument paying for a

rating to bolster the price at which that instrument can then be sold on the market based on the

perceived stability that the rating indicates.

With increasing deregulation came increasing dependence on CRAs. As a direct result of

deregulation, banks began to create “a range of highly-rated asset-backed transactions and

collateralized bond obligations, as well as derivative product companies, financial guarantor

transactions...”71 These assets, in turn, required regulatory approval that manifested itself in the

form of requiring high ratings from NRSROs. As financial products increased in complexity and

as collateralized debt and bond obligations became increasingly distant from the underlying

assets, investors and regulators alike relied on NRSRO’s to evaluate the safety of the underlying

assets. Furthermore, the proliferation of these complex assets underwent explosive growth, with

financial derivatives growing at a rate of 36% a year starting in 1986 to reach $3.5 trillion at the

end of 199172 and the MBS market growing from $500 million in 1996 to $3.2 trillion in 2003.73

                                                                                                               70 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services. “Rating the Rating Agencies: The State of Transparency and Competition.” April 2, 2003. HRG-2003-HFS-0054. 71 Frank Partnoy, “Overdependence on Credit Ratings Was a Primary Cause of the Crisis.” Eleventh Annual International Banking Conference: The Federal Reserve Bank of Chicago and the European Central Bank Credit Market Turmoil of 2007-08: Implications for Public Policy. http://www.law.yale.edu/documents/pdf/cbl/Partnoy_Overdependence_Credit.pdf 72 Eli M. Remolana, “The Recent Growth of Financial Derivative Markets” New York Federal Reserve, Quarterly Review. Vol. 17, 14, (1992).

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The confluence of these massive changes in the financial markets and the increasing role of

CRAs erupted in the Enron scandal of 2001. In one of the biggest corporate meltdowns in recent

history, Moody’s, Standard & Poor’s, and Fitch all rated Enron investment grade up until four

days before the company went bankrupt.74

After Enron, government officials and economists were very much aware of and discussing

the potential impacts of regulatory outsourcing to CRAs. First, there were a plethora of critiques

related to how NRSROs received national designation and the selection process for achieving

that status. The SEC established no clear guidelines for attaining NRSRO status, instead

publishing a public “no-action” letter that any financial institution could use the listed CRA to be

in compliance with SEC laws. The only factor that the SEC discussed as a central criterion is that

the CRA had widespread reputation and was nationally trusted. However, this created a self-

fulfilling prophecy, as new CRAs that wanted to gain national acceptance could not do so

without NRSRO status, while they could not receive NRSRO status due to the fact that they were

not nationally accepted. In 2001, only Moody’s, Standard & Poor’s, and Fitch were listed as

acceptable CRAs for the purpose of regulatory policy.75

As discussed by Partnoy, there was intense skepticism of the current “regulatory license”

model that had developed.76 During the time period, economists also debated whether CRAs

were actually adding value and providing information to the markets as opposed to reactively

                                                                                                                                                                                                                                                                                                                                                                     73 John J. McConnell and Stephen Buser. “The Origins and Evolution of the Market for Mortgage Backed Securities.” Annual Review of Financial Economics, Vol. 3. 173-192. (2011).  74 Claire A. Hill, Why Did Anyone Listen to the Rating Agencies After Enron?” Journal of Business and Technology. 283, (2009). http://digitalcommons.law.umaryland.edu/jbtl/vol4/iss2/3. 75 Richard Johnson. “An Examination of Rating Agencies’ Action Around the Investment-Grade Boundary.” Federal Reserve Bank of Kansas City. (2003). 76 Frank Partnoy, “Two Thumbs Down for the Credit Rating Agencies.” Washington University Law Quarterly, Vol. 77, (1999), 619-712. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=167412.  

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assigning ratings after public events altered the riskiness of a given asset.77 Additionally, debates

also centered on the methodologies employed by CRAs, with one study concluding that 75% of

CRA analysis was conducted based on data and 25% relied on subjective interpretations by the

rating institution.78 There was also significant discussion of how financial institutions were

engineering complex derivative products that purposefully manipulated CRA rating models to

produce high ratings despite elevated levels of potential risk.79 All of these complaints centered

on the same fundamental topic: serious concerns existed as to the whether CRAs were equipped

to serve as a vital part of the government regulatory structure given a wide breadth of critiques

related to their ability to accurately measure risk. Increasing the government role in evaluating

the safeness of assets seemed likely to produce higher levels of security. First, the federal

government would not have the profit motive to inflate ratings that was currently being discussed

as plaguing the effectiveness of CRAs in the market. Second, federal regulators had stronger

tools to gather information from companies seeking ratings as opposed to CRAs that were forced

to work with whatever data was provided by the institution seeking the rating. Nevertheless, the

possibility that the federal government would also fail at this task was still a lingering concern.

b) Legislative Analysis

The Reform Act of 2006 was the first legislative attempt to reform the market for credit

ratings. This law, however, did very little, if anything, to reform the structural regulatory

dependence on CRAs. During the rule-making process, thought was given to whether the federal

government should continue to rely on CRAs to provide this crucial function. Throughout the

                                                                                                               77 James Van Horne. Financial Markets Rates and Flows, 4th Edition (Englewood Cliffs, N.J.: Prentice Hall 1994), 181. 78 Lyn Perlmuth. “Is Turnabout Fair Play?” Institutional Investor, (1995), 34. 79 Partnoy, “The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies.”

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hearings and debate surrounding the law – both mechanisms of the path dependence model

manifest itself as the SEC and other federal actors demonstrated a clear lack of internal expertise.

Furthermore, the entrenched nature of CRAs in the regulatory processes and the financial world

at large was widely discussed as hindering potential reform. The legislative record of the 2006

law highlights how these two factors bound the scope of potential reforms through the law.

Furthermore, the fact that the law was overwhelmingly focused on changing the NRSRO process

to ensure competitiveness as opposed to decreasing the government’s dependence on CRAs

helps illustrate the path dependence model.

To address the myriad of concerns related to the role of CRAs in government regulation and

the financial markets, the 108th Congress began a set of hearings on the subject in 2003.

Furthermore, the Sarbanes-Oxley Act of 2002 mandated a study of the role of CRAs in

regulatory policy. The first of such hearings, on April 2nd of 2003 had ambitious goals, as

described by Chairman Richard Baker: “It is my hope that we can examine in some detail the

manner by which these organizations are designated, the adequacy of our current regulatory

oversight methodologies and the basis for which such organization is either to be given approval

or the methodology for revocation of such authority.”80 Interestingly, this list of potential goals

relates to how the federal government oversees and selects NRSROs, and not whether such a

regulatory outsourcing should exist in the first place. Throughout the legislative hearings – the

focus of the debate was around fostering competition in the field of credit analysis and conflicts

of interest in the market, though the issue of government regulatory outsourcing was discussed to

some degree. During this hearing, Chairwomen Nazareth of the SEC noted that the oversight

                                                                                                               80 HRG-2003-HFS-0054

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capabilities of the SEC were “very limited” citing the lack of legislative authority granted to the

SEC to oversee how NRSROs conducted their business.81

i) Regulatory Outsourcing and the Lack of Internal Expertise

The lack of internal expertise by the SEC to handle the role that CRAs played in the financial

markets was clear and repeatedly demonstrated. This idea was perhaps best captured by Nazareth

during the first hearing on the subject of CRA reform: “But I can say that, in general what makes

this area so difficult and the reason that we never seem to come to closure on how to address

these issues is that, fundamentally what is occurring here is financial analysis.”82 The SEC’s

clear discomfort with critiquing or overseeing any sort of “financial analysis” in the private

sector may have stemmed in part from a lack of actual or perceived expertise to carry out this

role. In fact, the only individual in the first hearing that suggested that the federal government

carry out the role of analyzing the riskiness of assets was Professor Lawrence White from New

York University, stating that “the first and best [path] is to have the financial regulators withdraw

those safety delegations and to make the safety judgments themselves.”83 This comes in sharp

contrast to the SEC’s testimony that never even hinted at the idea of having the federal

government step in and come up with their own system of evaluating risk for the purposes of

federal and state law.

Private CRAs in the marketplace that were looking to compete with Moody’s and Standard &

Poor’s also voiced an incredulous view that the SEC could perform this role. Sean Egan, head of

Egan-Jones, stating, “ I question whether bank regulators would be able to catch Enron or

                                                                                                               81 HRG-2003-HFS-0054  82 HRG-2003-HFS-0054 83 HRG-2003-HFS-0054

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Worldcom or Genuity. I do not think they have the training, the incentives, the tools to do it.”84

Egan’s perspective on how to improve the market for asset information was to statutorily

mandate an investor-pay model, and his firm positioned themselves as the only CRA providing

quality information to investors as opposed to the practices of the major actors in the market that

boosted ratings to enhance profits and their client base.

A consistent theme throughout the hearings for the Reform Act of 20006 was an

overwhelming reluctance by the SEC to take any firm stance on a regulatory structure for

NRSROs and deep resistance to further inclusion in conducting the risk analysis that they had

previous outsourced to the NRSROs. The SEC had never performed this role and was hesitant to

engage in a new and potentially risky area of regulatory oversight, which compounded the

private sector’s distrust of having the SEC play a larger regulatory role in the field.

ii) Regulatory Inertia and the Entrenchment of CRAs

Throughout the debate surrounding the 2006 law – the entrenched nature of CRAs in the

regulatory process was frequently discussed. First, in an April hearing, Raymond McDaniel,

President of Moody’s, highlighted that “…the interaction of regulation with the rating agency

industry as a practical matter, has become very broad and deep and it would be difficult to

reverse that process.”85 Congressman Paul Kanjorski, reflecting on White’s proposal of having

the government end the outsourcing of regulatory responsibility, stated “but then we would have

to back up and change a lot of prior regulation that used that standard,” indicating an explicit

recognition of the costs of transition and the entrenched nature of CRAs in the regulatory

                                                                                                               84 HRG-2003-HFS-0054  85 HRG-2003-HFS-0054

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process.86 Even academics participating in the hearings noted, “there is a very large, very

complex interlocking web of regulations and statutes, both at the federal and state level…How to

move forward with a market solution when faced with this interlocking web – or to change the

metaphor, a Gordian Knot, - of regulation and rules did puzzle me.”87 Numerous references to

the constraints posed by the lengthy regulatory history illustrate the pervasive impact of

regulatory entrenchment.

The highly imbedded nature of regulatory outsourcing to CRAs in a multitude of policy

sectors at the state and federal level also played a role in the conversation regarding the removal

of NRSRO status altogether to foster greater competition. James Kaitz, President and Chief

Executive Officer for the Association for Financial Professionals, stated, “I would suggest if you

do that, you have eliminated an artificial barrier to competition, and you have erected a

permanent barrier to competition. As we have all discussed, the ratings are embedded in banking

law, insurance, mutual funds, and potentially into the pension area. So that would create a

permanent barrier to competition from any other organizations.”88 Due to the advantages given

through NRSRO status for so long, removing the status without promoting competition in some

other fashion would handicap potential market participants. When the SEC held a public

comment period on various areas of interest regarding the role of CRAs and asked whether or not

industry participants would support the removal of the NRSRO status – 42 of the 46 recipients

said they would not be in favor, many citing that the process of unwinding the regulatory system

would be costly and complicated.89

                                                                                                               86 HRG-2003-HFS-0054 87 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Reforming Credit Rating Agencies: The SEC’s Need for Statutory Authority.” April 12, 2005. HRG-2005-HFS-0064. 88 HRG-2005-HFS-0064 89 HRG-2005-HFS-0064.

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The debate between Congressman Kanjorski and Jim Kaitz, head of the Association for

Financial Professionals, sums up the nature of this debate quite succinctly:

“Mr. KAITZ. It might be a nice way to think about it, but it is totally unrealistic. You have to undo legislation and regulation and all those regulated portfolios to do away with the NRSRO - Mr. KANJORSKI. Congress doesn't have to do anything? Mr. KAITZ. It is embedded in insurance, mutual fund, banking regulation. You would have to then address each one of those separate pieces of legislation. Mr. KANJORSK. We have created a monster. Now we have to dress that monster?”90 There was clear recognition and consideration of the fact that the proliferation of dependence on

CRAs had a binding effect on the potential for reform. Any potential changes would have to be

reconciled with the fact that years of state and federal dependence would be incredibly costly to

undue – limiting the ability for federal actors to remove the NRSRO language and to shift

responsibility back to federal regulators.

c) Conclusion

The legislative records and hearings surrounding the Reform Act of 2006 provide strong

support for the path dependence model and the mechanisms previously identified. First, the lack

of internal expertise was clearly described by both the SEC and private actors who all argued that

the SEC was not equipped to play such a large regulatory role. Second, the entrenched nature of

NRSROs was frequently discussed in the context of potential reform, indicating that regulatory

entrenchment constrained the set of policy options available to Congress when reform was

considered. These factors resulted in the Reform Act of 2006 being limited to just codifying a

selection process for CRAs to become registered with the SEC. Furthermore, many critics

contended that the criteria established for registering with the SEC were anti-competitive,

                                                                                                               90 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Legislative Solutions for the Rating Agency Duopoly.” June 29, 2005. HRG-2005-HFS-0051.  

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resulting in minimal changes to the competitive landscape of the industry.91 The Reform Act of

2006 did not in any way alter the fact that the federal government was still highly dependent on

the quality of the ratings produced by NRSROs in a host of regulatory fields without any direct

process for ensuring the effectiveness of those ratings.

C) 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act

Dodd-Frank also features both of the mechanisms of path dependence featured previously,

strengthening the hypothesis and path dependent model. Throughout the legislative process, the

SEC and other federal regulators expressed an inability to perform the role of CRAs while

regulatory entrenchment continued to bind potential policy reform. These forces culminated in

preventing substantial legislative intervention. Since the background, setting, and impact of the

financial crisis were already described previously, I will begin my analysis of the legislation and

the evidence of the two mechanisms of the path dependent model in the hearing process leading

up to the final regulations and rules.

a) Legislative Analysis

Throughout the legislative record, both the lack of expertise at the federal level and the cost

of removing CRAs from the regulatory process are discussed at length, with both factors limiting

the scope of potential reform. First, it is important to note that the widespread failure of CRAs

                                                                                                               91 Greg Gordon. “Industry Wrote Provision that Undercuts Credit-Rating Overhaul.” McClatchy. August 7, 2013. http://www.mcclatchydc.com/2013/08/07/198739/industry-wrote-provision-that.html

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during the crisis initially emboldened Congress to take a holistic view of the role of CRAs in the

financial markets. Most notably, Senator Richard Shelby asked during a Senate hearing in

September of 2007 to Chairman Cox of the SEC, “if you were to create a new system would you

design it differently? And if so, how so? Obviously, the system is flawed.”92 Thus, on the onset,

a wide range of policy alternatives was at least being considered. Over time, however, as the

system of dependence on CRAs was explored, the policy alternatives reduced to a more practical

set of outcomes, demonstrating the binding effects of past regulatory decisions.

i) Regulatory Outsourcing and the Lack of Expertise

The hearings for Dodd-Frank support the hypothesis that both private and public actors

did not trust the SEC to produce accurate assessments of the safeness of assets. This view was

championed by Robert Auwaerter of Vanguard (an American investment firm) stating, “I

question whether they have the resources to do it right now, to go out to the agencies and

determine that the processes are working right.”93 This was also agreed upon by Represenative

Scott Garrett from New Jersey, who stated “So two things I do not think Congress of the SEC

should do…prescribe exact analytics that NRSROs must use.”94 Both of these statements echoed

the deep distrust that both public and private actors towards the SEC’s ability to be an effective

regulator of CRAs and the complex analysis they were now carrying out in the market.

Furthermore, think-tanks weighed in on the conversation, with Alex J. Pollock of the American

Enterprise Institute rebuking the proposals to increase the SEC’s role: “The worst case would be

to turn the SEC, through the regulation of ratings process, which could easily turn into regulating

                                                                                                               92 HRG-2007-BHU-0027 93 U.S. House. Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises; Committee on Financial Services. “Approaches to Improving Credit Rating Agency Regulation.” May 19, 2009. HRG-2009-HFS-0032. 94 HRG-2009-HFS-0032.

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ratings, into a monopoly rater, which would also suffer from the same lack of ability to predict

the future.”95 Interestingly, proponents of less government intervention framed the work of

CRAs as trying to “predict the future.” The contrast between this seemingly speculative task and

the vast importance of this role in determining policy surrounding the safety of assets is striking.

Though there was discussion of having the federal government play a larger role in the

regulatory sphere, such discussions were always coupled with a pervasive sense of frustration

with the glacial pace of change by the SEC. Congressional and private actors simultaneously

critiqued the SEC with Congress lamenting the slow pace of reform since 2006 and the private

sector representatives arguing that the regulatory body didn’t have the capacity do effectively

oversee the system. This lack of trust, and implicitly the lack of expertise, was a consistently

cited in the legislative record and informed the final results of Dodd-Frank. On net, Dodd-Frank

did increase the regulatory role of the SEC, but stopped short of giving the agency any direct role

over the analytical processes conducted by CRAs.

ii) Regulatory Inertia and the Entrenchment of CRAs

On the onset of Senate hearings regarding the immense failures of CRAs during the

financial crisis, the experts called in to testify on potential remedies to the problems seen in the

market were clear: the government needed to play a greater role in evaluating the riskiness of

assets. According to John Coffee, Adolf A. Berle Professor of Law at Columbia Law School,

“…the SEC should compute the default rates using its own criteria, not letting the agencies do it

themselves because they will use different criteria.”96 Chairman of the SEC Christopher Cox

concurred with this idea, opining, “Professor Coffee’s proposals in that respect are very

                                                                                                               95 HRG-2009-HFS-0032. 96 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Role and Impact of Credit Rating Agencies on the Subprime Credit Markets.” September 26, 2007. HRG-2007-BHU-0027.

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consonant with at least what I am thinking and I believe what the Commission staff and perhaps

the other Commissioners are thinking.”97

Alternatively, if the federal government was going to continue to depend on CRAs,

Coffee argued for a harsher set of punishments: “But I do not think absent some kind of either

liability risk of possibility of suspension or forfeiture that we are going to have the same

governmental oversight powers over the rating agencies that we have over the accounting

profession or the securities analysts.”98 Furthermore, a very promising model was introduced

where the SEC would approve a pool of CRAs, a company would request a rating from the SEC,

and the SEC would assign the task at random to one of the approved CRAs. Thus, the incentive

problems for bad ratings would be addressed in addition to randomizing the process to ensure

high-quality work product.99 Another important proposal repeatedly discussed was the idea that

any information shared with a given CRA must be proliferated to other CRAs to ensure a larger

amount of analysis being conducted in the market and a more fruitful level of competition.100

Thus, the inclusion of a broad role for government involvement for assessing the safety

of assets and making those results public was on the table for inclusion in the legislative process.

Furthermore, Professor Coffee suggested that CRAs that consistently produced faulty ratings

should lose NRSRO status, and that information shared with NRSROs during the rating

generation process should be shared with other CRAs that wish to conduct an analysis and check

the results of their competitors. All of these suggestions produced bold, robust changes to the

regulatory framework for CRAs.

                                                                                                               97 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Turmoil in U.S. Credit Markets: The Role of Credit Rating Agencies.” April 22, 2008. HRG-2008-BHU-0025. 98 HRG-2008-BHU-0025 99 HRG-2009-HFS-0032 100 U.S. Senate. Committee on Banking, Housing, and Urban Affairs. “Examining Proposals to Enhance the Regulation of Credit Rating Agencies.” August 5, 2009. HRG-2008-BHU-0052.

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These broader goals, however, were stifled by the realities of regulatory entrenchment.

When asked about the SEC’s codified dependence on CRAs through their rules and regulations,

Chairman Cox definitively stated, “…we will not be able to purge, by any means, our rules of

reference to ratings.”101 Furthermore, according to many industry participants, the damage was

already done. According to Sean Egan, the historical dependence on specific CRAs, “In that time

period, what has happened is that because the government only recognized those few rating firms

and continued this unsound business model, it enabled the issuer-compensated rating firms to

grow much faster, much further, and have a more consolidated industry than it would be

otherwise.”102 Nevertheless, as noted by Stephen Joynt, President of Fitch, “…without

designating anyone, the present incumbents would be more likely to be used by investors for the

good reasons that they're used right now, in referencing ratings, and I think it might inhibit

competition and diversity of opinion.”103 Thus, unraveling the regulatory license system already

in place may have had little effect on the actual quality of ratings and competition in the markets.

Essentially, years of regulatory entrenchment had given the top CRAs a complete dominance of

the market and unbeatable head start that small challengers could not hope to overcome, stifling

the possibility of broad scale reform. As bemoaned by Senator Chuck Schumer, “so the ratings

are too much a part of our financial system to abandon them, but it is clear the system as it exists

is broken.”104

iii) Conclusion

                                                                                                               101 HRG-2008-BHU-0025 102 U.S. House. Committee on Oversight and Government Reform. “Credit Rating Agencies and the Financial Crisis.” October 22, 2008. HRG-2008-CGR-0079. 103 HRG-2009-HFS-0032 104 HRG-2009-BHU-0052.

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First, it is important to note what changes were actually codified in Dodd-Frank in

regards to reigning in abuses in the market for credit information. Dodd-Frank did successfully

remove references to NRSROs across a wide set of federal regulations, raise the liability for

CRAs, and lower the bar for the SEC to pursue enforcement action. Broader reform, however,

such as the creation of a new oversight system or the random assignment of CRAs to the analysis

of a deal, was lost in the legislative process. Based on the evidence available, the lack of

expertise within the SEC and the entrenchment of CRAs in the regulatory process rendered

widespread reform unattainable. The SEC’s relatively new role in the regulatory space was

evident in the fact that they barely had created a group within the agency to study CRAs after the

financial crisis of 2008. Furthermore, the substantially entrenched role of CRAs in the regulatory

process made broader ideas of reform far more complicated than Congress was prepared to

tackle. Though House and Senate members hypothesized bold changes, they were often greeted

with a highly entrenched system. Regardless of whether the NRSRO system was maintained or

removed – there was a feeling that regulatory intervention was too late. The top firms had

already cemented their market share, and regulators could only hope to potentially instill greater

quality ratings in the midst of a sub-optimal regulatory framework.

Chapter V: Conclusion

In this paper, I have sought to establish one primary claim: to understand the regulatory

aftermath of credit rating agency reform, history matters. More specifically, turning points in

regulatory decision making in the 1930’s and 1970’s codified pervasive dependence on private

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CRAs, generating a path dependence model that restricted future legislative choice despite two

major attempts at reform. This path dependence model manifested itself through two central

mechanisms. First, by outsourcing regulatory responsibility to private CRAs, the SEC and other

regulators never developed the capacity to carry out this work internally while high levels of

proficiency and market reputation consolidated in the private sector, specifically among Standard

and Poor’s, Moody’s, and Fitch. This lead public and private actors to protest against any

increase in federal oversight over CRAs and credit analysis. Second, the decision to outsource

regulatory responsibility at the federal level spread rapidly among different federal laws and

statutes, state laws and statutes, and various other regulatory policy spheres, increasing the cost

of alternative policy solutions and biasing regulatory reform towards maintaining the status quo.

The combined effect of both phenomena was the reduction and restriction of regulatory

options when reform was pursued during 2006 and 2010. Though regulators sought a variety of

mechanisms to reform systemic flaws in the market for credit information, proposals to

dramatically enhance the government’s role in evaluating credit risk internally failed. First, the

lack of expertise at the federal level and the absence of a historical track-record of successful

regulation in the field lead to a lack of support for a larger regulatory role for the SEC by both

public and private actors. Second, the entrenched nature of CRAs in the regulatory process was

consistently mentioned as increasing the cost of effective reform. Alternative modes of oversight

were all forsaken in favor of smaller scale changes to disclosure and liability rules.

Though the evidence outlined provides strong support for the idea that the historical

trajectory of regulatory policy limited the scope of legislative reform, it does not authoritatively

reject alternative hypothesis that the politics or threats posed by CRAs were the main drivers of

the lack of reform. Though those aspects cannot be proven wrong, the prominence of those

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processes in driving the regulatory outcome are suspect in light of the robust evidence that

connects the historical policy path to the current set of outcomes observed. On net, this analysis

strengthens the argument that the historical path influenced the final policy outcome observed.

If regulatory bodies in the 1930’s and 1970’s had designed an internal system for

measuring asset risk as opposed to regulatory outsourcing, it is possible that more effective

measurement strategies could have been developed within the federal government that may have

better detected issues in the financial sector leading up to the crisis of 2008. This view, however,

is arguably naïve. A common thread among economists is that the high levels of complexity in

the markets for assets such as mortgage-backed securities posed a new threat to understanding

the safeness of assets. If the federal government, as opposed to private CRAs, was able to apply

scrutiny to these practices, however, they may have been able to detect this worrisome trend

earlier and could have potentially reduced the economic and social cost of the 2008 recession.

The reforms created by both the 2006 and 2010 laws, ultimately, have had little impact

on the market for asset information. If these reforms were having the kind of impact that

legislators hoped, we would hypothetically have seen a higher level of competition in the market

for asset information. Net revenues and stock prices from both S&P and Moody’s, however,

paint a different story. All in all, financial indicators show that both companies continue to enjoy

high levels of revenue and increasing stock prices, indicating a complete absence of regulatory

enhanced competition.

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Table 3: S&P’s and Moody’s Net Revenues Post Crisis105

Table 3: McGraw Hill Financial Inc. Adjusted Closing Price: 1985-201

                                                                                                               105 Revenue data provided by YCharts. https://ycharts.com/.

MCO:  Moody’s  Corporation  MHFI:  McGraw  Hill  Financial  Inc.  (owners  of  Standard  and  Poor’s)  

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Table 4: Moody’s Adjusted Closing Prices: 1994-2014106

Table 5: Standard and Poor’s Closing Prices: 1994-2014107

                                                                                                               106 Yahoo Finance Data: Moody’s Corporation (MCO). Accessed May 4, 2015. 107 Yahoo Finance Data:    McGraw  Hill  Financial,  Inc.  (MHFI).  Accessed  May  4,  2015.    

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According to Raymond McDaniels, CEO of Moody’s, CRAs suffered from “serious

reputational damage” after the financial crisis.108 In contrast, the data paints the picture of a

sector that remains highly consolidated, profitable, and unshaken by the lessons of widespread

financial hardship. Despite two major efforts at regulatory reform, Moody’s and Standard and

Poor’s are still on top. In this paper, I argue that the historical dependence on these institutions to

carry out a central regulatory role proved too much to overcome. Years of dependence created a

web of regulation that, in the end, stood the test of time despite widespread evidence that the

system was simply not working.

There are, however, several limitations in this study. First, this analysis has not fully

disproved the alternative hypothesis. Capture arguments may still be applicable, and

understanding the nature and scope of the political battles being waged during the financial crisis

requires in-depth interviews with the participating parties to understand the relationship between

CRAs, Wall Street, Congress, and the SEC. These arguments are less persuasive, though, in the

context of minimal lobbying expenditures by CRAs. Furthermore, Lindblom’s analysis of

privileged positions may also apply in that the historical dependence allowed CRAs to utilize the

“punishment” that changes to the CRA model would cause massive disruptions in the market.

This argument, though, is also suspect given that the country was emerging from one of the

worst financial crises on record. Given that CRAs had failed so dramatically, the threat that their

ratings could send the country back into recession does not come across as plausible.

Additionally, unlike the fields of defense spending and the major financial institutions on Wall

Street, government dependence on these CRAs to preserve the health of the economy is much

                                                                                                               108 HRG-2008-CGR-0079

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more indirect. Finally, this study is a rhetorical analysis of statements made during both

historical junctures and the legislative record before the passage of the Reform Act of 2006 and

Dodd-Frank. These anecdotes can never fully capture the thoughts, attitudes, and beliefs of the

market and government participants at the time of rule making and legislation and is limited in

that respect.

Looking forward, there are a variety of areas of potential research. First, more empirical

measures of the effectiveness of CRAs post crisis will be crucial. It is entirely possible that the

2006 and 2010 reforms will bring about more accurate ratings as measured by lower downgrades

or other market measures over time, and sustained empirical research on this phenomenon will

be essential to further understanding the effects of reform. Furthermore, this analysis is severely

limited by timing: Dodd-Frank is a recent piece of complex legislation that may take many years

to implement and take effect. Perhaps the necessary seeds to introduce competition have been

planted and will come to fruition as the competition matures and market actors fully internalize

the fact that they no longer need to rely on NRSROs for regulatory purposes. Lastly, a more

thorough understanding of the politics of the relationship between the SEC, Congress, and CRAs

would lead to a more holistic understanding of the dynamics of reform. Arguments surrounding

concepts such as capture, though immensely important, are limited by the lack of geographic and

interpersonal access that I had in carrying out and implementing this research. Individuals in a

position to engage some of the “insiders” involved in the rule-making, testimonies, and back

room deals that eventually shaped the legislative outcome would more fruitfully explore

approaches such as capture that seek to understand the interpersonal and cultural elements of the

legislative process.

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This paper seeks to add to the body of work on path dependence and the role that historical

analysis can play in political science. Qualitative evidence and purposeful process tracing still

provide important tools for understanding the evolution of regulatory development, helping

anchor recent shifts in the underlying trends that shape the outcomes observed. Path dependence

provides the most robust mechanism for understanding the substantial limits placed on potential

credit rating agency reform. Moving forward, hopefully Congress will be able to overcome the

specter of this path dependence and adopt bold reforms that remove the myriad of issues

identified in the market for asset information. Furthermore, this paper helps put into context the

many tradeoffs associated with outsourcing key regulatory decisions to the private sector.

Though doing so may be efficient in the short-run, long-term changes in the regulated market

might create serious incentive and governance problems that lead to widespread distress.

Government actors should heed the example of CRAs with caution when approaching future

regulatory outsourcing decisions.

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