The argument for this better way requires an understanding of the history of the bond
rating industry, the history of the prudential regulation of financial institutions’ bond portfolios,
and the intertwining of those two histories that began over seven decades ago. It also requires an
understanding that the bond markets are overwhelmingly an institutional market, where the buy
and sell decisions are made by bond managers at financial institutions and not by retail investors.
Laying out this argument will be the goal of this article. The orientation of this article
will be on the U.S. experience;
1
but the lessons surely carry over to how credit rating agencies
are or are not regulated in other countries.
II. The Role of Credit Rating Agencies
A central issue in finance – perhaps the central issue in finance – is the uncertainty of a
lender as to whether a borrower will repay a loan. The critical problem is one of asymmetric
information: The borrower usually knows more about the prospects for repayment than does the
lender. As a consequence, before extending a loan, lenders will gather extensive information
about prospective borrowers, so as to try to determine which are the more creditworthy
1
Other discussions of this experience can be found in: Lawrence J. White, "The Credit Rating Industry: An Industrial
Organization Analysis," in Richard M. Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating Agencies,
and the Global Financial System, Kluwer (Boston, 2002), pp. 41-63; Lawrence J. White, "The SEC's Other Problem,"
Regulation
, 25 (Winter 2002-2003), pp. 38-42; Lawrence J. White, "Good Intentions Gone Awry: A Policy Analysis of
the SEC's Regulation of the Bond Rating Industry," Policy Brief #2006-PB-05, Networks Financial Institute, Indiana
State University, 2006; Lawrence J. White, "A New Law for the Bond Rating Industry," Regulation
, 30 (Spring 2007),
pp.48-52; Lawrence J. White, “The Credit-Rating Agencies and the Subprime Debacle,” Critical Review
, 21, Nos. 2-3,
2009, pp. 389-399; Matthew C. Richardson and Lawrence J. White, "The Rating Agencies: Is Regulation the Answer?"
in Viral Acharya and Matthew C. Richardson, eds., Restoring Financial Stability: How to Repair a Failed System
. New
York: Wiley, 2009, pp. 101-115; Richard Cantor and Frank Packer, "The Credit Rating Industry," Journal of Fixed
Income, 5 (December 1995), pp. 10-34; Herwig Langohr and Patricia Langohr, The Rating Agencies and Their Credit
Ratings: What They Are, How They Work, and Why They Are Relevant, Wiley (Chichester, 2008); Frank Partnoy, "The
Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies," Washington University Law
Quarterly, 77 No. 3 (1999), pp. 619-712; Frank Partnoy, "The Paradox of Credit Ratings," in Richard M. Levich,
Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating Agencies, and the Global Financial System
, Kluwer
(Boston, 2002), pp. 65-84; Timothy J. Sinclair, The New Masters of Capital: American Bond Rating Agencies and the
Politics of Creditworthiness, Cornell University Press (Ithaca, 2008); and Richard Sylla, "An Historical Primer on the
Business of Credit Ratings," in Richard M. Levich, Carmen Reinhart, and Giovanni Majnoni, eds., Ratings, Rating
Agencies, and the Global Financial System, Kluwer (Boston, 2002), pp. 19-40.