The Asymmetric Role of States in Empowering and Dis-Empowering Transnational Regulatory Intermediaries: Insights from the Case of Credit Rating Agencies
In the decades before the recent Global Financial Crisis, public rule-makers in virtually all OECD countries “hard-wired” CRAs’ ratings into financial regulation. Especially in the 1990s and 2000s, the regulatory use of credit ratings became an ever more widely used instrument of financial market regulation in the US and also travelled to other national and international regulatory systems (e.g. through the Basel II standards on banking supervision). When their ratings were used for regulatory purposes (e.g. to define investment restrictions or capital reserve requirements), CRAs served as intermediaries (I) fulfilling risk-assessment functions on behalf of public financial market regulators and supervisors (R). Making use of CRAs’ credit risk assessments allowed public rule-makers to impose risk-sensitive regulatory requirements on financial market actors such as banks or institutional investors (rule targets, T) without having to conduct their own credit risk assessments. Through regulatory use, public rule-makers granted CRAs regulatory authority as they made CRAs’ private standard of credit-worthiness publicly binding. Moreover, they also bolstered CRAs’ expert authority and elevated their status as authoritative gatekeepers of global financial markets. At the same time, public regulation and oversight of CRAs were weak.
But at least since the Global Financial Crisis lingering allegations have gained traction that CRAs committed blatant errors of judgment on numerous occasions and that the rating industry suffered from a number of fundamental pathologies. As a result, overreliance of investors and regulators on CRAs has widely been identified as an instance of market and policy failure that needs to be redressed. Public rule-makers have now sought to rein in CRAs’ authority via re-regulation, tighter oversight and a reduction of the regulatory use of credit ratings, which would amount to a formal rescission of delegated regulatory authority.
However, public dis-empowerment of CRAs has been hesitant, incomplete and hardly consequential. On the one hand, the implementation of new laws (such as the US Dodd Frank Act of 2010) and rules providing for a cut of regulatory references to credit ratings has proved complicated and lagged well behind regulatory objectives. Arguably even more importantly, CRAs’ “sticky” authority has meanwhile become rather resilient to formal re-regulation and especially to states’ (threats of) rescinding delegated regulatory power. CRAs continue to co-determine access to capital markets and costs of borrowing; investors still follow CRAs’ standard of creditworthiness, and even powerful states zealously seek to preserve their top ratings. Thus, public rule-makers have been severely constrained when it comes to controlling and rolling back their intermediaries’ private authority.
To understand why and how public rule-makers which initiate indirect governance schemes sitting in the driver’s seat may still not stay there in the longer run, we need theoretical tools that take seriously the endogenous dynamics and the downstream effects that public empowerment of private intermediaries may have on public governance and control capacities, including their ability to reverse the empowerment of private intermediaries. Such dynamic theories which would help to make sense of the asymmetric role public rule-makers have played in the empowerment and dis-empowerment of CRAs are currently lacking. This signifies not only an analytical lacuna; the question whether the empowerment of private intermediaries and the privatization of governance functions (such as the outsourcing of credit risk assessment) are self-reinforcing or ultimately controllable by democratically answerable public rule-makers also has normative relevance from the perspective of democratic accountability and sovereignty. Therefore, this paper introduces and applies a new explanatory framework for the public (dis-)empowerment of private regulatory intermediaries. This framework combines insights from principal-agent theory (on public-private delegation, regulatory control and re-scission), IPE conceptions of private authority (on genuinely private sources of authority) and historical institutionalism (on path-dependent post-delegation dynamics).
This theorization and my empirical analysis of CRAs suggest two main (broader) lessons for the study of (private) regulatory intermediaries. First, the privatization of governance functions and private authority evolve path-dependently. Later dis-empowerment of private regulatory intermediaries is not impossible, but, due to functional (material) and ideational (immaterial) mechanisms which jointly shape path-dependent regulatory trajectories, it gets more costly and more difficult the farther the privatization of governance functions has progressed. Second, the larger the autonomous resource base of private regulatory intermediaries (such as CRAs) and the stronger their genuinely private authority (i.e. their status as “an authority”), the less leverage public rule-makers will have over private intermediaries and the more difficult it gets for public rule-makers to implement effective control mechanisms.