The Colonization of U.S Financial Regulation By Credit Ratings during the Interwar Period (1926-1938)
Dramatic times do not always trigger historic decisions. And when they do, the historical significance of such decisions may only become clear in retrospect, through logics of discovery and rediscovery. The building of credit ratings into regulatory frameworks in the U.S. during the Great Depression would have a global, historical influence that has only become visible in the later decades of its influence. From 1930 to 1938, a series of promulgations by the Office of the Comptroller of the Currency and other government authorities laid the foundations for the practice known as regulatory reliance on ratings, the use of ratings for regulatory purposes. The Interwar experiment proved short-lived, as war preparations and, later, strict international capital controls imposed under the Bretton Woods era considerably reduced the flow of private capital. Nonetheless, the posterity of early U.S. rating experimentations is now well established: rating-based regulations have experienced a massive revival in the U.S. and Europe during the post-Bretton Woods period. Today, credit ratings agencies (hereafter referred to as CRAs) rate hundreds of thousands of financial instruments, including the sovereign bonds of over a hundred countries (Carruthers 2013; Langohr and Langohr 2010; Sinclair 2005). Since the 1970s, regulators have increasingly relied on CRAs’ forecasting capacities to carry out their tasks of market surveillance and monitoring (Cantor et al. 2007; Estrella 2000; Partnoy 1999 and 2002). The practice of using ratings in market regulations has become so widespread that it has become a “tacit” rule in the contemporary regulatory activity.
The incorporation of credit into U.S. regulatory frameworks during the 1930s was an event of historical significance. Since their emergence in the early 20th century in the United States, credit ratings have spread internationally to every corner of the financial world to become pivotal reputational intermediaries for private and public (including sovereign) financial entities. In comparison, the question of the historical processes which made possible the incorporation of ratings in regulatory frameworks remains mysterious.
This paper seeks to elucidate the set of factors explaining the early incorporation of credit ratings in regulatory frameworks. Why did credit ratings take hold and prosper as mediums of regulation during the Great Depression? How can we make sense of the circulation of ratings from the private (business) to the public (bureaucratic) sphere? In understanding how these two worlds became linked in the instruments they share, which notion should we use: delegation, colonization, contagion, transplantation, enrollment, recruitment or borrowing? Recounting the genesis of regulatory reliance on ratings (hereafter referred to as RRR) brings to the fore important questions of historical and sociological nature.
First, RRR highlights a distinguished feature of bureaucratic life in the 1930s: beyond the creation of scores of new agencies, the New Deal also and crucially orchestrated considerable innovation and diversification regarding policy instrumentation. One interesting fact about early forms of RRR is that they were conducive to the expansion of regulatory frameworks in the U.S. A major regulatory achievement during the Great Depression, RRR sets us thinking about how regulators think during times of crisis, when the sense of emergency requires bold and innovative interventions.
Second, and looking back in history, we can also use RRR to cast a critical eye on pre-Depression U.S. regulatory networks. A core claim of this paper is that RRR served to fix several contractual hazards affecting the structure and dynamics of U.S. regulatory frameworks. Here, the rising significance of credit ratings in regulatory frameworks is best analyzed with a set of factors discontinuous, rather than analogous, to the reasons that made ratings popular among private actors or court juries.
Finally, the 2008 crisis brought awareness to the regulatory authority of CRAs. These private technologies, produced outside regulatory agencies but incorporated within regulatory frameworks raise theoretical and political problems. The notion of delegation is often presented as a key for understanding the legal role played by CRAs. However, this notion is both theoretically unstable and historically underdetermined Much of the research on credit rating agencies regards them as embedded in a principal-agent relationship with the state, where regulators are principals who delegate some portion of their tasks to rating agencies as agents. In thinking about how U.S. financial regulators began to make use of bond ratings during the Great Depression, this paper seeks to avoid the mistake of thinking of this as a type of delegation (from public authorities to a private party). Not only the delegation thesis does not accurately analyze the series of transactions through which regulators imported ratings into the bureaucratic arena, but it does not anymore convincingly describe how ratings got diffused within the regulatory network.
This paper proceeds in six acts. The first section provides a systematic analysis of the contractual hazards affecting the workings of pre-Depression U.S. regulatory networks (1900-1929). I assess these hazards against the problem that represented the increasing significance of investment securities in banks activities. The second sections retraces organizational changes within the Federal Reserve Bank of New York (FRBNY). Focusing on the work conducted by Carl Snyder within the FRBNY’s statistical division, I examine the elaboration of the so-called bond quality index, the first rating artifact in the regulatory network. The third section discusses the multi-layered borrowing processes that enable the OCC to borrow in 1931 the rating-implied method devised by the FRBNY. The fourth section attends to the diffusion and radicalization of rating-implied methods as instruments of forbearance and purification across the regulatory network during the period 1931-1936. The fifth section compares the merits of rating-based promulgations against the several contractual hazards listed in section 1. The sixth section discusses the pitfalls of RRR by focusing on metrological practices and resistance in bank examinations.