100 Iowa L. Rev. 1619 (2015) 

Download PDF

Abstract

Sovereign ratings are designed to mitigate investors’ risk exposure by highlighting the fiscal condition of governments. The problem is that sovereign ratings entail reciprocal oversight of rating agencies and sovereign governments—which raises conflicts of interest and, ironically, creates incentives for distorted risk assessments. Private rating agencies hold sovereign governments accountable by assessing their risk exposure, while sovereign governments hold rating agencies accountable through regulation. Both sovereign governments and rating agencies have incentives to leverage their mutual oversight to obscure risk taking and minimize accountability. During booms, governments and rating agencies have convergent interests in understating risks until market bubbles are on the cusp of bursting because bubbles produce higher tax revenue and profits. During busts, both sides blame one another for failing to accurately gauge risks, which fosters regulatory stalemates that perpetuate the absence of public and private accountability. Once the dust settles, the cycle of risk tolerance continues again with neither set of actors providing meaningful oversight of the other as both rating agencies and governments benefit from the renewed growth of the financial sector.

Overseeing rating agencies is difficult for sovereign governments because they face the temptation to abuse regulatory powers to neutralize rating agencies’ ability to push back and expose the fiscal overstretch of governments. The simple alternative would be to utilize a self-regulatory organization approach to balance the need for regulation with rating-agency independence. But the stumbling block for self-regulation is that rating agencies are an oligopoly as three firms account for 96% of ratings, and self-regulation could reinforce the market power and entrenchment of the leading rating agencies. Instead, this Article advocates an intermediation strategy of integrating a broader array of ratings stakeholders into a stakeholder regulatory organization to oversee the industry. A range of stakeholders rely on the accuracy and integrity of ratings and would have an interest in ensuring that rating-agency regulation balances the need for greater procedural and substantive accountability with the need for rating-agency independence from the government. This approach would not deal with the other side of the coin— the fiscal overstretch of sovereign governments that have exposed them to increasing rating-agency scrutiny, which is a far more complex problem that is beyond the scope of this Article. But the logic is that integrating end users of ratings into deliberative processes will mitigate industry biases and produce rules that preempt the need for government regulation.