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The Consequences of the Global Financial CrisisThe Rhetoric of Reform and Regulation$

Wyn Grant and Graham K. Wilson

Print publication date: 2012

Print ISBN-13: 9780199641987

Published to Oxford Scholarship Online: September 2012

DOI: 10.1093/acprof:oso/9780199641987.001.0001

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Institutional Failure and the Global Financial Crisis

Institutional Failure and the Global Financial Crisis

(p.139) 8 Institutional Failure and the Global Financial Crisis
The Consequences of the Global Financial Crisis

Timothy J. Sinclair

Oxford University Press

Abstract and Keywords

Who could have imagined the obscure, arcane business of debt rating would become — in the context of the worst economic and financial crisis since the Great Depression — a matter for serious public comment by presidents and prime ministers? The public debate about the role of the rating agencies in the generation of the subprime crisis revolved around an idea which now seems deeply entrenched in popular, financial market and academic understandings of the agencies and their incentives. The core element of this thinking is that how the agencies are regulated generates a significant weakness in the ratings they produce. This chapter argues that the concern with regulation of the rating agencies is largely mistaken. Regulation is concerned with the ‘rules of the road’, not with the design of the road itself. The road is the problem, not the rules we invent to govern it. Although criticism of the agencies may serve a useful political purpose, too much attention to this issue will produce complacency about the inherent volatility of global finance, setting the world up for a repeat of the Global Financial Crisis once the appetite for risk returns.

Keywords:   rating agencies, blame, crisis, debt, bonds, capital markets, regulation, asset-backed securities

Who could have imagined the obscure, arcane business of debt rating would become—in the context of the worst economic and financial crisis since the Great Depression—a matter for serious public comment by presidents and prime ministers? Rating agency officials are used to their work being discussed at length in the financial press, often with a mixture of awe and contempt. The awe is derived from the influence rating has had on the interest premiums paid by corporations and governments and by the cash-rich nature of the rating business prior to the financial crisis. The contempt seems to be driven by a view on Wall Street that the people who work in the agencies are second-raters, not good enough for the once-mighty investment banks. Raters are, however, not used to being the subject of mainstream media attention.

The often vitriolic public debate about the role of the rating agencies in the generation of the subprime crisis has revolved around an idea which now seems deeply entrenched in popular, financial market and academic understandings of the agencies and their incentives. A major element of this thinking is that how the agencies are regulated generates problems for the quality of the ratings they produce. In this chapter, I argue that the concern with regulation of the rating agencies is largely mistaken. Regulation is concerned with the “rules of the road,” not with the design of the road itself. The road is the problem, not the rules we invent to govern it, as I show in what follows.

I begin this chapter with a short review of the agencies, their history, and how they function. This is followed by an examination of the role the rating agencies play in the New Global Finance (NGF). The chapter then considers financial crisis: perspectives on crisis, a history of crises, and the current crisis that began in the summer of 2007, including the issue of blame. I follow this (p.140) with some discussion of the regulatory response, such as it has been. I then argue that the Global Financial Crisis (GFC) is not a result of rule transgression, but is a crisis at the level of the social relationships which make global finance possible. This is why the crisis is so deep and why it is so hard to develop a response by policymakers and market actors. The nature of this crisis transcended the very definition of crisis as understood by these actors.

Where Do Rating Agencies Come From?

The energetic reaction of European financial regulators to the perceived culpability of the agencies in the generation of the subprime crisis points to the increasingly important job done by wholesale credit rating agencies in global markets. In fact, it was not too many years ago that rating agencies were little known outside the United States. Until the mid-1990s, most European and Asian companies relied on their market reputations alone to secure financing. But this changed when the pressure of globalization led to the desire to tap the deep American financial markets and to a greater appetite for higher returns (and thus risk). In these circumstances, the informality of the traditional old boys’ networks is no longer defendable to shareholders or relevant to pension funds half way around the world. The result is that an essentially American approach to market organization and judgment has become the global norm in the developed world, and increasingly, in emerging markets as well.

Ratings have become increasingly central to the regulatory system of modern capitalism and therefore to governments. Getting credit ratings “right” therefore seems vitally important to many observers. But in pursuing improvement in the rating system we need to appreciate the challenges and limits to rating. The increasingly volatile nature of markets has created a crisis in relations between the agencies and governments, which increasingly seek to monitor their performance and stimulate reform in their procedures. Given the inherent challenges in rating it must seem paradoxical that rating is growing in importance as an approach to information problems in a variety of contexts outside the financial markets (Sinclair, 2005). This form of regulation is increasingly important in health, education, and many other commercial activities.

Rating agencies emerged after the Civil War in the United States. From this time until World War I, American financial markets experienced an explosion of information provision. The transition between issuing compendiums of information and actually making judgments about the creditworthiness of debtors occurred after the 1907 financial crisis and before the Pujo hearings of 1912. By the mid-1920s, 100 percent of the US municipal bond market was rated by Moody’s. The growth of the bond rating industry subsequently (p.141) occurred in a number of phases. Up to the 1930s, and the separation of the banking and securities businesses in the United States with passage of the Glass–Steagall Act of 1933, bond rating was a fledgling activity. Rating entered a period of rapid growth and consolidation with this separation and institutionalization of the securities business after 1929, and rating became a standard requirement to sell any debt issue in the United States after many state governments incorporated rating standards into their prudential rules for investment by pension funds. A series of defaults by major sovereign borrowers, including Germany, made the bond business largely a US one from the 1930s to the 1980s, dominated by American blue chip industrial firms and municipalities (Toffler, 1990: 43–57). The third period of rating development began in the 1980s, as a market in junk or low-rated bonds developed. This market—a feature of the newly released energies of financial speculation—saw many new entrants participate in the capital markets.

Two major American agencies dominate the market in ratings. Both Moody’s and Standard and Poor’s (S&P) are headquartered in the lower Manhattan financial district of New York City. Moody’s was sold in 1998 as a separate corporation by Dun and Bradstreet, the information concern, which had owned Moody’s since 1962, while S&P remains a subsidiary of publishers McGraw-Hill, which bought S&P in 1966. Both agencies have numerous branches in the United States, in other developed countries, and in several emerging markets. S&P is famous for the S&P 500, the benchmark US stock index listing around $1 trillion in assets. Other agencies include Fitch Ratings and the Dominion Bond Rating Service.

In the late 1960s and early 1970s, rating agencies began to charge fees to bond issuers to pay for ratings. Both firms have fee incomes of several hundred million dollars a year, making it difficult for even the largest issuer to manipulate them through their revenues. Moreover, issuing inflated ratings would diminish the reputation of the major agencies, and reputation is the very basis of their franchise. Rating agency outputs comprise an important part of the infrastructure of capital markets. They are key benchmarks in the marketplace, which form the basis for subsequent decision-making by participants. In this sense, rating agencies are important not so much for any particular rating they produce, but for the fact that they are a part of the internal organization of the market itself. So, we find that traders may refer to a company as an “AA company,” or some other rating category, as if this were a fact, an agreed and uncontroversial way of describing and distinguishing companies, municipalities, or countries.

A rationalist way to think about what rating agencies do is to see them as serving a “function” in the economic system. In this view, rating agencies solve a problem in markets that develops when banks no longer sit at the center of the borrowing process. Rating agencies serve as what Gourevitch (p.142) calls “reputational intermediaries” like accountants, analysts, and lawyers, who are “essential to the functioning of the system,” monitoring managers through a “constant flow of short-term snapshots” (Gourevitch, 2002: 1, 11). Another way to think about the function of the agencies is to suggest rating agencies establish psychological “rules of thumb” which make market decisions less costly for participants (Heisler, 1994: 78).

But purely functional explanations for the existence of rating agencies are deceptive. Attempts to verify (or refute) the idea that rating agencies must exist because they serve a purpose have proven inconclusive. Rating agencies have to be considered important actors because people view them as important, and act on the basis of that understanding in markets, even if it proves impossible for analysts to actually isolate the specific benefits the agencies generate for these market actors. Investors often mimic other investors, “ignoring substantive private information” (Scharfstein and Stein, 1990: 465). The fact that people may collectively view rating agencies as important—irrespective of what “function” the agencies are thought to serve in the scholarly literature—means that markets and debt issuers have strong incentives to act as if participants in the markets take the rating agencies seriously. In other words, the significance of rating is not to be estimated like a mountain or national population, as a “brute” fact which is true (or not) irrespective of shared beliefs about its existence, nor is the meaning of rating determined by the “subjective” facts of individual perception (Ruggie, 1998: 12–13). What is central to the status and consequentiality of rating agencies is what people believe about them, and act on collectively—even if those beliefs are clearly false. Indeed, the beliefs may be quite strange to the observer, but if people use them as a guide to action (or inaction) they are significant. Dismissing such collective beliefs misses the fact that actors must take account of the existence of social facts in considering their own action. Reflection about the nature and direction of social facts is characteristic of financial markets on a day-to-day basis. Rating agencies are important in investment most immediately because there is a collective belief that says the agencies are important, which people act upon, as if it were “true.” Whether rating agencies actually add new information to the process does not negate their significance, understood in these terms.

Rating agencies operate in a specific context. The NGF is a form of social organization in which rating agencies and other reputational intermediaries assume a new importance. Bank lending is familiar to us. Banks traditionally acted as financial intermediaries, bringing together borrowers and lenders of funds. They borrowed money, in the form of deposits, and lent money at their own risk to borrowers. However, in recent years, disintermediation has occurred on both sides of the balance sheet. Depositors have found more (p.143) attractive things to do with their money at the same time as borrowers have increasingly borrowed from nonbank sources. The reasons for this development seem to lie in the heightened competitive pressures generated by globalization, and the high overhead costs of the bank intermediation infrastructure. Disintermediation is at the center of the NGF. It is changing what banks are, and creating an information problem for suppliers and users of funds. In a bank-intermediated environment, lenders depend on the prudential behavior of banks, which are regulated and required to maintain a certain proportion of reserves. However, in a disintermediated financial environment, those with funds must make their own judgments about the likelihood of repayment by borrowers. Given the high costs of gathering suitable information with which to make an assessment by individual investors, it is no surprise that institutions have developed to solve the information problem in capital markets by providing centralized judgments on creditworthiness.

The growth of rating has a number of central features. Globalization is the most obvious characteristic. As noted, cheaper, more efficient capital markets now challenge the commercial positions of banks everywhere. The New York-based rating agencies have grown rapidly to meet demand for their services in newly disintermediating capital markets. Second, innovation in financial instruments is a major feature. Derivatives and structured financings, among other things, place a lot of stress on the existing analytical systems and outputs of the agencies, which are developing new rating scales and expertise in order to meet these changes. The demand for timely information is greater than ever. Third, competition in the rating industry has started to accelerate for the first time in decades. The basis for this competition lies in niche specialization (e.g., Fitch Ratings in municipals and financial institutions) and in the “better treatment” of issuers by smaller firms. The global rating agencies, especially Moody’s, are sometimes characterized as high-handed, or in other ways deficient in surveys of both issuers and investors.

How Do We Understand Financial Crisis?

It is possible to distinguish two main ways of understanding financial crises that compete for scholarly and political preeminence. The first of these has dominated economic thought about finance for thirty years and has had a major influence on policymakers. This stream of thought I call the exogenous approach to financial crisis. Although invoking Adam Smith, this tradition’s modern founders include Friedrich von Hayek and Milton Friedman. Their views are associated with attacks on the mixed economy model of state intervention popular in much of the developed world after the Great Depression of the 1930s. These thinkers took it as axiomatic that markets, when left (p.144) to their own devices, are efficient allocators of resources. For them, financial crisis is a deviation from the normal state of the market. Given they assume markets work efficiently, this tradition focuses on “external” causes, especially government failure, as the cause of crisis. Friedman, for example, blamed the Great Depression of the 1930s on what he considered to be incorrect Federal Reserve policy in 1929 and 1930, rather than the effects of the stock market crash in October 1929 (Kindleberger and Aliber, 2005: 72).

Exogenous accounts of financial crisis assume market participants are constantly adjusting their behavior—for example, whether they buy or sell financial instruments like bonds and stocks—based on new information from outside the market. In this context, market prices are assumed to always reflect what other market participants are prepared to pay. If this is the case, reason exogenous thinkers, prices are never inflated or false. They must always be correct. So the idea of a “bubble economy,” in which assets like houses, stocks, and oil futures deviate from true value to a higher, false value, is rejected. There can be no “true value” other than what the market is prepared to pay.

The endogenous account, with which I am sympathetic, says that financial crises begin primarily inside finance. For Marx and Polanyi, crises are caused by the internal “laws of motion” of capitalism. These produce constant change and upheaval, not equilibrium between demand and supply. For Keynes, the “animal spirits” or passions of speculation give rise to risky behavior. Typical of the endogenous perspective is the idea that market traders do not merely integrate information coming from outside the markets in the wider, real economy, but are focused on what other traders are doing, in an effort to anticipate their buy/sell activities and thus make money from them (or at least avoid losing more money than the market average). Given this, rumors, norms, and other features of social life are part of their understanding of how finance works. On this account, finance is subject to the pathologies of social life, like any other activity in which humans engage. This is an image of finance far from the self-regulating conception that characterizes the exogenous view.

Keynes provided what remains perhaps the best intuitive illustration of the importance of this internal, social understanding of finance and financial crises in his tabloid beauty contest metaphor, first published in 1936 (Akerlof and Shiller, 2009: 133). Keynes suggested that the essence of finance is not, as most supposed, a matter of picking the best stocks, based on an economic analysis of which should rise in value in future. Anticipating what other traders in the market were likely to do was actually more relevant. Keynes compared finance to beauty contests that ran in the popular newspapers of the time. These contests were not, as might be assumed, about picking the most attractive face. Success was achieved by estimating how others would vote and voting with them, although as Keynes pointed out, others would be trying to do the same, hence the complexity and volatility of financial markets.

(p.145) More specifically, in a useful synthesis of some of the writings that fall within what I have termed the endogenous approach to global finance, Cooper has argued that the traditional assumptions made about markets and their tendency to equilibrium between demand and supply do not work for assets like houses, art, and financial instruments like stocks, bonds, and derivatives (Cooper, 2008: 9–13). In the market for goods, greater demand can be met with greater supply or higher prices. But this simple economic logic does not work for assets. Instead, demand often grows in response to price increases for assets. The “animal spirits” identified by Keynes and elaborated upon by Akerlof and Shiller do not produce stability in the market for assets like they do in the market for goods. In the absence of equilibrium, there is no limit to the expansion of market enthusiasm for financial assets or houses, producing what we have come to call a “bubble” economy. Unfortunately, as we know, bubbles tend to deflate in an unpredictable manner, with very negative consequences for economic activity.

What is the History of Financial Crises?

The history of financial crises shows that they are always shocking events, as they typically occur after long periods of affluence. The reversal crises represent seems incomprehensible to those at the center of things, never mind the general public. The standard against which all financial crises are measured is, of course, the Great Depression of the 1930s. At the height of the Depression, a quarter of American workers were unemployed (Galbraith, 1997 [1955]: 168). The New York Stock Exchange did not return to its summer 1929 value until the early 1950s, almost a quarter century after the crash of October 1929 (www.djindexes.com). However, financial crises did not start in the twentieth century. The Dutch “tulip mania” of the 1630s, in which tulip bulbs greatly appreciated in value, is usually cited as the first boom and bust. At the time, tulips were exotic imports from the eastern Mediterranean. “Mass mania” for the bulbs led to massive price inflation, so that some tulip bulbs were worth the equivalent of $50,000 or more each. When the crash came and the bubble deflated, “not with a whimper but with a bang,” many who had invested their life savings in tulips lost everything (Galbraith, 1993: 4). Mass default ensured a depression in the Netherlands in the years after 1637 (Galbraith, 1993: 26–33). More recently, the 1907 financial panic came about after the failure of a trust company at the center of Wall Street speculation (Bruner and Carr, 2007). Calamity was avoided by cooperation between major banks, led by J.P. Morgan.

After the Great Depression and World War II, the Bretton Woods system was created to bring greater order to the global financial system. As much a (p.146) political as a financial system, Bretton Woods was intended to avoid rapid and unsettling economic adjustment within countries. The hope was that this would avoid the sort of economic problems which contributed to World War II and which would, no doubt, increase support for the communist system in Russia. Although the intent behind Bretton Woods was to avoid crises and the political conflict that followed, despite US assistance, it had few resources at its disposal. Given considerable protectionism in trade after World War II, countries were frequently either in considerable surplus or deficit in the national accounts that measured their trade and payments with the rest of the world. This led to crisis-driven efforts to restore balance, often aggravating relations with other states.

The Bretton Woods system, fixed exchange rates, and controls over the movement of capital were gradually abandoned in the developed world during the fifteen years after 1970. What emerged was a new system in which floating exchange rates were increasingly the norm at least in developed countries, and in which capital could flow freely around the world to find the highest returns. Although a floating exchange rate regime should rapidly and effectively adjust to reflect the changing economic conditions in a country (real interest rates, inflation, profit margins, regulations, political stability), this system proved less than perfect. The 1980s was marked by a series of currency crises, as the values of major currencies like the Japanese yen appreciated, causing trouble for their trade partners. Perhaps the most dramatic of these crises was the ERM (Exchange Rate Mechanism) crisis of 1992, in which currency traders, especially George Soros, placed bets on the ability of the British government to keep pound sterling within the European ERM. At the end of the crisis, the British government abandoned defending sterling, which depreciated substantially and had to be removed from the ERM.

The Asian Financial Crisis of 1997–8 was the culmination of a boom in East Asia that led to what in hindsight turned out to be excessive short-term lending and risky pegging of national currencies to the US dollar, a problem also for Argentina in 2001. Like Holland in the 1630s, the result of the crisis was economic depression in some countries, notably Indonesia, where the price of basic foodstuffs increased dramatically. The Asian crisis, like the financial crisis that began in 2007, led to criticism of lax regulation, fraud, and corruption. In Malaysia, despite a barrage of criticism, controls on the movement of capital were reintroduced until the panic pressures eased.

Who is to Blame for the Current Crisis?

The subprime crisis that began in the summer of 2007 should rank as one of the most traumatic global developments of the last hundred years. It caused dismay (p.147) and panic throughout elite circles in developed countries as efforts to reignite confidence in the financial markets were frustrated again and again. Given that the subprime securities market was worth only $0.7 trillion in mid-2007, out of total global capital markets of $175 trillion, the impact of subprime assets is out of all proportion to their actual weight in the financial system (Bank of England, 2008: 20). The “subprime crisis” is not a direct consequence of subprime mortgage delinquencies. The paralysis that came over global finance is a consequence of the social, intersubjective nature of markets, rather than the logical result of relatively minor problems with lending to the working poor. But this analysis of the subprime crisis is difficult to incorporate in a rationalist view of markets, in which events have logical causes. In a rationalist world, panics, crises, and collapses have to be explained as a result of specific failures rather than understood as a consequence of the interactions of social life.

Since the 1930s, financial crises have almost always been accompanied by public controversy over who was at fault. Before the 1930s, governments were not generally held responsible for economic conditions, but since the 1930s the public have increasingly expected governments to manage problems in the financial system. Inevitably, efforts to defuse or redirect blame develop. During the Asia crisis, corruption in Asian governments and among their business leaders was held responsible, even though just a few years before “Asian values” were supposedly responsible for the unprecedented growth in the region. During the Enron scandal of 2001–2, auditors were blamed for not revealing the financial chicanery of the corporation. The subprime crisis has been no different, with rating agencies, mortgage lenders, “greedy” bankers, and “weak” regulators all subject to very strong attacks for not doing their jobs.

The rating agencies have been subject to unprecedented criticism and investigation. Congressional committees, the Securities and Exchange Commission (SEC), the European Parliament and Commission, and the Committee of European Securities Regulators all conducted investigations. A very senior rating official has indicated that the crisis over subprime ratings is the most threatening yet experienced by the agencies in their century of activity. This effort to blame the agencies is a curious reaction, given that the rating agency business is now open to greater competition since passage of the Credit Rating Agency Reform Act of 2006. It suggests that the movement from regulation to self-regulation—from “police patrol” to “fire alarm” approaches—has not eliminated the role of the state. Governments are still expected by their citizens to deal with market failure, and when necessary act as lenders of last resort, and they know it. What we see is a serious disciplining of the agencies by a regulatory state, intent on improving their performance (Moran, 2003: 1–11).

The agencies are not in a position to offer the capital markets a solution to the information problem about the underlying assets of these securities, as they are on their home turf of municipal, corporate, and sovereign rating. The (p.148) agencies, like market participants, cannot know about the circumstances of each homeowner. The markets are able to apply the same financial tools to the structured offerings that the agencies use. Because of this lack of information in the case of structured bonds, all the agencies were doing was lending their reputation or brand to securities where they do not have a comparative advantage in information.

Will Regulating the Agencies Change Anything?

Concerns about the role of rating agencies in the subprime crisis have generated renewed interest in regulating the agencies. The activities of rating agencies have been largely free of regulation. Starting in the 1930s, the ratings produced by the agencies in the United States have been incorporated into prudential regulation of pension funds so as to provide a benchmark for their investment. This required pension funds to invest their resources in those bonds rated “investment grade” and avoid lower rated, “speculative grade” bonds. Regulation of the agencies themselves only starts in the 1975 with the SEC’s Net Capital Rule. This gave a discount or “haircut” to issuers whose bonds are rated by “National Recognized Statistical Rating Organizations” (NRSROs). No criteria were established for NRSROs at the time, and this status was determined by the SEC informally. NRSRO designation acted as a barrier to entry until the Rating Agency Reform Act of 2006, passed in the wake of the Enron scandal, created criteria and a recognized path to NRSRO recognition.

Two major sets of concerns dominate discussions about the rating agencies in the wake of the GFC. The first is to do with the competence of the agencies and the effectiveness of their work. The second set of concerns relate to broader, structural issues. Critics have frequently attacked the timeliness of rating downgrades, suggesting that the agencies do not use appropriate methods and fail to ask the sort of forensic questions needed to properly investigate a company. Concerns about staffing, training, and resourcing are associated with these problems. Recently and increasingly stridently, critics have attacked what are perceived to be broader, structural problems in how the agencies do business. These problems, suggest the critics, create poor incentives and undermine the quality of the work the agencies undertake.

The first of these broader structural issues is the legacy of weak competition between rating agencies as a result of the introduction of the NRSRO designation. Although several new agencies were designated NRSRO after passage of the Rating Agency Reform Act, many critics would like NRSRO status abolished, removing any reference to ratings in law. The view implicit here is that weak competition has led to poor analysis, as the rating agencies have had few (p.149) incentives to reinvest in their product. In this view, the revenues flowing to rating agencies are rents from a government-generated oligopoly.

Concerns about how the agencies are funded became widespread with the onset of the subprime crisis. The idea was that the issuer-pays model, although established for forty years, was a scandalous conflict of interest because it means that the agencies have incentives to make their ratings less critical than they would if they were paid by investors, the ultimate users of ratings. Like NRSRO status, many critics called for an end to the issuer-pays model of rating agency funding.

A vigorous—if often poorly informed—debate about the merits of regulating rating agencies has taken place since the onset of the crisis in spring 2007. Behind the rhetoric, it is very clear that both American SEC and European Commission officials are reluctant to either regulate the analytics of the rating process itself or the business models of the major rating agencies. In amendments to NRSRO rules announced in February 2009, SEC enhanced required data disclosures on performance statistics, methodology, and prohibited credit analysts from fee setting and negotiation or from receiving gifts from those they rate (SEC, 2009). How ratings are made and who pays for them are materially unaffected by these changes. This is also the case with the Dodd–Frank Act, 2010, which mandated further SEC reporting.

Much the same can be said for European efforts. Hampered by the reality that Moody’s and S&P are both headquartered in the United States, for many years rating agencies were little more than “recognized” in European states by local regulators who were free-riders on American regulatory efforts. With the Enron crisis, concern about rating agencies grew and the IOSCO code of conduct was increasingly referred to as a useful form of self-regulation. With the onset of the GFC, European Commission officials have sought to regulate the agencies in Europe with proposed new laws recently passed by the European Parliament for referral to the Council of Ministers (EU Commission, 2008; European Parliament, 2009). This legislation, which is premised on local enforcement, creates a registration process like the NRSRO system, addresses the limited issues of transparency, disclosure, and process (Kessler, 2009: 11). But it does not change rating analytics or challenge the issuer-pays model of rating funding.

What is More Important?

Two impulses seem to dominate responses to major crises. The first is to search for and attach blame to those who are alleged to have brought the crisis about, the culprits. This provides material for the media and incessant chatter in blogs. This impulse gives rise to panels of bankers who are forced to apologize (p.150) for their alleged errors in front of Congressional and British Parliamentary committees.

If this first impulse is politically useful, embarrassing to a few, and somewhat satisfying to many others, the second impulse is, in the circumstances of this crisis, more likely to damage collective welfare. The second impulse is to create—typically in haste—a framework of regulative rules that are “heavier” or “harder” or somehow more “serious.” The impulse to regulate is derived from a failure to understand what is it that the rating agencies did that was actually in error, and a failure to accept the social nature of finance and the circumstances that brought this crisis into being in the first place.

The prevailing understanding behind the impulse to punish and regulate seems to be that the people involved were doing things wrong. It is as if the mechanic fixing your car has downloaded the wrong software updates to the car’s computers. No tip for him then and perhaps a remedial visit to mechanics school or the sack when the next round of layoffs comes. But this mechanical analogy will not do for global finance. Finance is not, contrary to the financial economists and their Efficient Markets Hypothesis, a natural phenomenon. While financial markets may display regularities in normal times, these regularities are not law-like because change is an ever-present feature of all social mechanisms.

John Searle made a useful distinction relevant to this problem. He suggested it is possible to distinguish regulative rules that “regulate antecedently or independently existing forms of behavior …” from a much more architectural form of rule (Searle, 1969: 33). These other “constitutive rules do not merely regulate, they create or define new forms of behavior.” He goes on to suggest that chess and football are only possible with rules. The rules make the game. The point here is that the public and elite panic has focused on regulative rules and those who allegedly broke them. But this is not the problem with rating agencies or what has brought about the GFC. Constitutive rules have been damaged, and this is why the crisis is so deep and so obviously challenging to the powers that be.

In the case of the rating agencies, what I would term regulative issues are insubstantial and no more than a useful rhetorical device to address poor forecasting. What are important and little commented upon are the constitutive issues. The major problem has been going on since the early 1980s and the rise of structured finance. Structured finance is important because it has been the major means through which financial innovation has made illiquid debts like credit card receivables, car loans, and mortgages into tradeable, liquid securities. In a context of low interest rates and the hunt for yield, structured finance has grown into around 40 percent of total global debt securities of around $30 trillion.

(p.151) When people think of financial innovation, they inevitably think of computers and highly educated “rocket scientists” developing quantitative techniques for managing risk. But that is not at the heart of this matter. Lawyers are at the heart of this issue. The real essence of structured finance is the legal rights to revenues organized in the contracts and trusts which underpin the securities. This documentation can run into thousands of pages. The point is that these legal underpinnings give different rights to different tranches of a security. Some, such as the AA tranche, have the right to be paid first, while others have had to wait in line. This is how a mass of not very creditworthy subprime mortgages could produce some AAA bonds. These investors had first right to pay revenue and the expectation was that even if some subprime mortgage holders defaulted as expected enough would pay so that those with highly rated securities would be paid in full. Unfortunately, when expectations are upset and people are full of uncertainty as in 2007–9, this model does not work and the securities of this type look dubious. Add recession and perhaps depression to this picture and you can imagine a wholesale write-down of the global market in securities.

But as disastrous as this is, the rating agencies’ real failure was something else: their move into the markets themselves. For decades, Moody’s and S&P had played the role of a judge or referee, standing back from the action and making calls as necessary. This role is what they were valued for and it is this which allowed them to build up reputational assets. The problem is that structured finance is only possible with the active involvement of the rating agencies. The agencies and their ratings actually make the distinct tranches of structured finance possible. Because of the complexity of the legal documentation and protection necessary for these tranches, the raters did not operate as neutral judges here. In structured finance, the raters increasingly acted as consultants, helping to construct the securities themselves, indicating how they would rate them if organized in particular ways.


It is intriguing that despite the worst financial crisis since the 1930s and the identification of a suitable culprit in the rating agencies, proposed regulation should be so insubstantial, doing little to alter the rating system that has been in place in the United States since 1909 and Europe since the 1980s. Part of this can be put down perhaps to a lack of confidence on the part of regulators and politicians in the efficacy of traditional solutions to market failure. It may also recognize the weakness of ostensibly heavily regulated institutions such as commercial banks and an understanding that the financial system is, despite the rating crisis, likely to continue to move in a more market- and (p.152) rating-dependent direction in future. Indeed, the rating agencies have been major beneficiaries of the bailout program, reporting substantial returns during the crisis (Ng and Rappaport, 2009).

The GFC was a crisis at the constitutive level. It reflects a deep loss of confidence in the basic infrastructure of the capital markets. This loss of confidence is a social rather than a technical process and tinkering with regulative rules, while tempting and politically distracting, will not address the heart of the matter. Like the Great Depression, it seems likely that the damage done to the social relationships which underpin global finance, such as the reputational assets of the rating agencies and the trust financiers have in each other, may take many long years to rebuild and could be wiped out again by renewed crisis perhaps stemming from sovereign debt default. It is tempting in these circumstances to prescribe a simple fix, but institutions, contrary to some, develop over time and, like communities, do not heal instantly. Encouraging institutional diversity and restraining hubris about alleged cures is advisable. For the rating agencies, attending to the relationships and the expectations that built their reputations in the first place is their best course of action. The extent of substantial change is likely to be limited.

As noted, two very different understandings of financial crisis compete. The first, the exogenous view, sees finance itself as a natural phenomenon, a smoothly oiled machine that every now and then gets messed up by the government, or events that nobody can anticipate, like war or famine. The other perspective, the endogenous, argues that the machine-like view of finance is mythic. Like all other human institutions, finance is a world made by people, in which collective understandings, norms, and assumptions give rise periodically to manias, panics, and crashes. On this account, financial crises are normal. What is not normal, concede those who support the endogenous perspective, is the expansion of financial crises into global events that threaten to destabilize world politics, as did the Great Depression of the 1930s.

Whether you adopt an exogenous or endogenous view of financial crises, the necessity for international cooperation to combat them is essential. In the first instance, this probably amounts to no more than ensuring that governments and central banks communicate about their efforts to support vulnerable financial institutions, especially when those institutions operate, as so many do, in multiple jurisdictions. While there is evidence of this in recent times, there was also much unilateral, uncoordinated action intended for national advantage, such as the Irish government’s guarantee of all funds deposited in domestic banks. Building up the institutional capacity for cooperation between finance ministries and central banks should be a priority. Political management will remain at the center of financial crises. Governments, whether they like it or not, know they have responsibility for financial stability and they have become adept at identifying and disciplining (p.153) institutions that do not seem to serve their purpose within the financial system. As a result, “witch hunts” will continue to be a key feature of the fallout of financial crises, as governments attempt to offload as much of the liability for crises as possible. Substantive regulatory change is likely to be muted by the lack of confidence among law makers in the United States and Europe in the efficacy of regulation in the face of rapid financial change. The weakness of the regulatory response is already evident in the character of the initiatives developed to “regulate” the credit rating agencies.

While truly global financial crises are rare, we understand so little about the mechanisms that cause crises that much greater modesty about how finance works seems sensible. I argue we should abandon our assumption that finance is natural like the movements of the planets, and instead embrace the lesson of Keynes’s beauty contest and the valuation crisis of 2007 that financial markets are social phenomena in which collective understandings, especially confidence, may be more important than ostensibly technical considerations. Although many academic assumptions remain resilient to change, it is apparent that, at least for now, the GFC of 2007–9 has created a greater sense of uncertainty in the world, and challenged the idea that globalization will deliver us all from want in a riskless way. It turns out that globalization is something that is unpredictable, that lurches in ways we cannot guess, and that even at the very heart of the global system can imperil great fortunes.

The relationship between global finance and politics has changed over the past hundred years. Before the twentieth century, governments had an interest in the smooth working of finance to fund the activities of the state, especially in relation to war. After 1929, governments, especially in the developed world, had a new role in preserving financial stability. After World War II, because of the absence of leadership between the wars, the United States assumed the central role in the design and implementation of a new global financial architecture of rules and institutions in support of an increasingly liberal order, but also one that at least in principle valued stability. After the Bretton Woods system of fixed exchange rates came to an end in the 1970s, the United States played a strong coordinating role in response to the increased financial volatility that went with renewed international capital mobility, especially in relation to exchange rate fluctuations. Given the unprecedented circumstances of the GFC that started in 2007, it is likely that a more activist stance on the part of the United States could be evident in future. Whether US leadership and interstate cooperation will be as effective today as they were in the 1940s and the 1980s remain to be seen.

Unfortunately, the pressure to return to asset price booms (and thus busts) remains strong. People seem attached to the empirically false proposition that property values only increase in real terms. But given the degree to which western governments promoted homeownership as a route to prosperity after (p.154) World War II, it is no wonder that people think this way. When we take the likelihood of future asset price bubbles into account, add in perennial developing country crises, and note the uncertain nature of market response at the top of bubbles and in busts, it seems almost inevitable that we will be dealing with financial crises on a regular basis in future, as in the past. Only through cooperation between major governments can we hope to ameliorate their worst effects and minimize their duration.


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