Manns on Rating the Rating Agencies

"The Reciprocal Oversight Problem"  
Iowa Law Review, Forthcoming

JEFFREY MANNS, George Washington University Law School

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. [...]

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. [...] [T]his 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. [...] [T]he 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.