Credit Ratings, Regulatory Reasoning, and Legal Change in the 20th and 21st Century


A review of Calculating and Governing Risk in Times of Crisis: The Role of Credit Ratings in Regulatory Reasoning and Legal Change (1930s-2010s), by Pierre Pénet.

Credit rating agencies (CRAs) have emerged as one of the main culprits for the recent global and European financial crises. The recognition that CRAs play a critical role in shaping the allocation of capital in financial markets has moved beyond academic circles to enter broader debates about the state-of-affairs and the future shape of the global and European financial systems. But despite the ever-growing interest in CRAs’ power, rating failures and regulation of CRAs, relatively little attention has been paid to how and why state regulatory authorities have used private credit ratings for regulatory purposes, for example in the calculation of risk-sensitive minimum capital requirements for banks. Thus, beyond a number of academic and policy-making specialists, there is still little recognition of how states have contributed to the rise of CRAs via regulatory use and how, on the other hand, regulatory reliance on CRAs has served public authorities to pursue their (varying) regulatory objectives and mandates.

Here is where Pierre Pénet’s dissertation makes an important contribution: He offers a both broad-ranging and meticulous historical account of regulatory reliance on ratings (RRR) in settled and crisis times that extends from the U.S. regulatory system of the 1930s to the European Union of the 2010s, including the 2012 decision of the European Central Bank (ECB) to suspend its minimum credit rating threshold for all Eurozone sovereign credit operations. Informed by the achievements as well as the limitations of existing academic approaches to RRR in finance, economic sociology and political science, Pénet formulates overall five research questions (pp. 30-33) which are addressed in six empirical chapters. In a nutshell, the dissertation explains: the genesis and evolution of RRR in the US (chs. 1-3) and its diffusion in Europe (chs. 3-4), the “rating inconsistencies” during the European sovereign debt crisis (ch. 5), and the decision of the ECB to suspend its regulatory use of ratings (ch. 6).

The introductory chapter outlines the research questions (pp. 30-33) as well as a framework for analyzing the origins, developments and complications of RRR in terms of the four components of (technological) DEVICE, LAW, STATE and HISTORY-TIME as well as their interrelations (pp. 34-46). Moreover, the primary data sources and methodology of data collection are introduced (pp. 46-57). Methodologically, the dissertation provides a comparative and historical, process-oriented, and qualitative analysis of RRR. It draws on the analysis of various documents, which are categorized as “stating”, “staging”, “canonical”, figuring” and “fictional” documents (pp.47-54), interviews with rating analysts and market-media information. The result of this sociological analysis at the interface of history, finance, and political science is an explanatory historical account of RRR and the broader regulatory regimes it enabled and supported. This account includes macro-histories of financial regulation in relatively tranquil market times (1820-1929 in ch. 1, 1944-2000 in ch. 3, and 1970-2005 in ch. 4) and a focused analysis of specific episodes of RRR in crises (1930-1938 in ch. 2, 2008-2010 in ch. 5, and 2008-2012 in ch. 6).

Chapters 1 and 2 answer the question why U.S. regulators began to incorporate ratings into public regulatory frameworks during the 1930s. As chapter 1 reconstructs, developments of security investment in the US, the rise of the regulatory state in finance and increasingly scientific methods of bank management in the late 19th and early 20th century prepared the ground for proactive financial regulations and the RRR that supported them. While regulatory attempts to this effect in the late 1910s and 1920s failed, they demonstrated the need for proper instrumentation of ratings to conduct proactive control of financial activities. Chapter 2 describes how US government authorities started to make use of credit ratings for regulatory purposes in the 1930s. Their practice of RRR is conceived as an “enrollment” which served to make use of ratings as a regulatory instrument of “appeal” (pp. 103-104). This instrument allowed for new regulatory interventions to avert bank failures and contain speculation.

Chapters 3 and 4 analyze why, after a post-war period of CRAs’ irrelevance, U.S. and European regulators harnessed ratings again to an even larger extent during the period from the 1970s to the 2000s. Chapter 3 retraces how the neoliberal transformations of deregulation, internationalization and disintermediation in the 1970s marked the “second coming” of RRR in the U.S. regulatory landscape. RRR became increasingly common, inter alia, in capital reserve requirements, restrictions on investments, disclosure requirements, and central bank operations. The chapter shows how this enrollment of ratings facilitated the shift from a “statutory” to a “disciplinary”, risk-sensitive regime of regulation in the U.S. (pp. 155-160). Moreover, RRR and disciplinary regulation diffused to European regulatory contexts. Chapter 4 then explains why European regulators proceeded to extend disciplinary RRR to the regulation of sovereign (rather than “merely” corporate) credit risks of states. When the ECB decided in 2005 to use ratings to condition the acceptance of government bonds as collateral for liquidity provisioning purposes, this served to introduce greater discipline in Eurozone monetary policies.

While chapters 1-4 take the view of the regulators at the time their regulations were promulgated, chapter 5 shifts the perspective in that it focuses on how CRAs “saw” the world and built scenarios for the future during the Greek sovereign debt crisis. It addresses two related questions: How can the rating inconsistencies during the European sovereign debt crisis be explained? How does sovereign ratingfailure” not simply result from technical errors but also from the constitutive techniques of plausibility, backward reasoning and reactivity which allow CRAs to adapt strategically to cognitive inconsistencies and credibility concerns? The explanatory account given in chapter 5 refutes conventional conceptions of CRAs as simply collecting additional information in times of unsettled markets and challenges the “inaccurate assumption” (p. 59) that failure of CRAs is “necessarily” predicated on corruption, conflicts of interest or profit-driven behavior. Tying in with social studies of finance (SSF) approaches to the constitutive and performative role of ratings in reality construction (rather than simply reality assessment), Pénet argues that CRAs did not merely “misread” the recent Greek crisis. Rather, CRAs made constitutive use of ratings. Consequently, as further elaborated in Chapter 6, “financial predictions embodied in CRAs’ ratings work[ed] as simulation-fictions rather than as scenario-hypotheses. Moody’s scenario could no longer be characterized as a set of testable hypotheses. Instead, it served as a fiction (or placeholder) which European regulators used to avoid (or delay) facing the prospect of a Greek default” (p. 251).

Finally, chapter 6 offers strategic reasons for why the ECB decided in 2010 and 2012 to suspend ratings from its collateral framework. It also reflects on how the calculation and governance of sovereign risk in Europe changed with the shift from regulation by ratings to austerity/loan contracts as principal instruments for governance. As the set of rating-implied rules and conditions governing the extension of credit and collateral policies in the Eurozone had become inapplicable (because the capacity of ratings to compute probabilities of default had disappeared), European regulators substituted the contractual terms and conditions of the Greek bailout for their typical rating-based scenarios. Retracing this shift, Pénet also shows that “the motivations behind austerity measures [for Greece] expressed European regulators’ ambition to maintain the illusion of calculation by other (exceptional) means rather than an attempt by ideologues to solve financial hardship with policy measures justified by their preferred macro-economic theory” (p. 252). Finally, the analysis in chapter 6 points to the existence of “mortality factors of RRR”: The ECB’s paradigmatic change reflects that RRR is an institution that can be abolished even though initiatives to a similar effect in the U.S. have hardly been implemented.

Pierre Pénet’s dissertation makes a number of important and insightful contributions to the literature on CRAs and the regulatory use of credit ratings. While there have been previous historical accounts of the regulatory of ratings in the U.S. and elsewhere, Pénet’s combination of broad-ranging but meticulous macro-history and the analysis of specific crisis episodes in both the US and the EU from the 1930s to the 2010s, is a major new addition to the literature. Despite the sweeping historical and geographical scope of the thesis, Pénet skillfully manages to retrace the many “small and silent decisions” (p. 47) in financial regulation that defined the role of RRR and had far-reaching consequences even though some of them looked hardly remarkable at the time of their promulgation. Even for this dense historical reconstruction alone the author must be commended. What is more, the dissertation is not only very rich in empirical terms; it also offers manifold and bold insights in theoretical and conceptual terms, as it challenges established wisdoms and opens up new perspectives on CRAs and their regulatory enrollment. In particular, the conceptualization of ratings as “clutching devices of regulatory change” (from a statutory to an appeal regime, from a statutory to a disciplinary regime, and from a disciplinary to a fictional regime) is an innovative way of grasping how regulators have made use of ratings as instruments of legal adjustment that “help concretize regulatory ambitions by providing solutions to regulatory intentions” (p. 253). In that process, ratings also led regulators to discover or invent new regulatory ambitions. I am sure this dissertation will be of great interest to many sociologists, historians, economists and political scientists working in this field. Speaking to important and diverse research traditions and issues surrounding credit rating and undoubtedly sparking analytical debates with its fresh and thorough insights, it will not fail to leave its mark.

Andreas Kruck
Geschwister-Scholl Institute for Political Science
Ludwig-Maximilians-University of Munich

Primary Sources
Documents (official documents, diaries & correspondence, rating methodologies & reports)
Nine interviews with rating analysts
Market-media information

Dissertation Information
Institut d’Études Politiques de Paris / Northwestern University. 2014. 301 pp. Primary advisors: Bruce Carruthers and Louis Chauvel.

Image: photograph by author

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