Why performativity limits credit rating reform

Stellinga, Bart Article Why performativity limits credit rating reform Finance and Society Provided in Cooperation with: Finance and Society Network (FSN) Suggested Citation: Stellinga, Bart (2019) : Why performativity limits credit rating reform, Finance and Society, ISSN 2059-5999, University of Edinburgh, Edinburgh, Vol. 5, Iss. 1, pp. 20-41, https://doi.org/10.2218/finsoc.v5i1.3016 This Version is available at: https://hdl.handle.net/10419/309369 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Email: b.j.p.st[email protected]. https://doi.org/10.2218/finsoc.v5i1.3016 Bart Stellinga University of Amsterdam, Netherlands Abstract The 2008 crisis made clear that credit rating agencies (CRAs) can contribute to systemic financial risk. Surprisingly, post-crisis reforms have hardly addressed the underlying problems, including rating agencies’ methodologies, their ratings’ homogeneity, and widespread market reliance on these signals. Current scholarship on CRA regulation blames policymakers’ unwillingness to fix systemic problems. This article draws on insights from the social studies of finance literature to provide a different explanation: the key obstacle is policymakers’ inability to fix these problems. The regulatory problem stems from performativity: risk assessments (including ratings) shape the risks they purport to merely describe. Adding to this literature, the article spells out how performativity limits credit rating reforms by making sweeping changes potentially harmful. Standardizing methodologies or setting up a public CRA could reinforce ratings’ homogeneity. Replacing ratings in regulation with market-based indicators might create worse systemic problems. The article then empirically details how EU policymakers, confronted with these dilemmas, ultimately steered clear of bold reforms. Keywords Credit rating agencies, performativity, regulation, financial crisis, systemic risk, procyclicality Introduction The ‘Big Three’ credit rating agencies (CRAs) – Standard & Poor’s, Moody’s and Fitch – play a crucial role in global financial markets.1It took the global financial crisis of 2007-9, however, to convince policymakers that ratings can contribute to systemic risk. Observers argued that ratings’ systemic problems had their roots in CRAs’ rating methodologies, market participants’ overreliance on these ratings (partly induced by their inclusion in regulations), and the homogeneity of the Big Three’s ratings (Morris, 2008; Sy, 2009). While these issues had surely been recognized before, policymakers had hitherto focused primarily on CRAs’ governance, in addition to their transparency to outside investors. Finance and Society 2019, 5(1): 20-41 © The Author(s) 10.2218/finsoc.v5i1.3016 Article 21 Finance and Society 5(1) Policymakers hoped this would ensure that investors were not duped by CRAs’ integrity problems, rooted in their issuer-pays business model (Mügge, 2011). The magnitude of the crisis led many to expect a fundamentally different approach: bold regulatory actions to tackle systemic problems. Critics argued that the pre-crisis focus on governance requirements would not suffice: regulators would have to get involved in the substance of both CRAs’ and firms’ risk assessment practices. They pleaded for a full removal of ratings from regulations, public control over CRAs’ methodologies, and a public alternative to the Big Three (Bofinger, 2009; Partnoy, 2009; Sy, 2009; Kruck, 2011). Surprisingly, only limited reforms were actually implemented. Policymakers have barely made progress in reducing (regulatory) reliance on ratings. They have also avoided prescriptive rules on the content of CRAs’ methodologies. And they have shied away from setting up a public CRA. Post-crisis rules still focus mainly on the governance of CRAs (and the market participants that use ratings), and predominantly address CRAs’ integrity problems. In short, there is much more continuity with the pre-crisis approach than expected. Why were the systemic problems not tackled through ambitious, substantive measures? Scholarship on CRA regulation provides many potential explanations. Institutionalist accounts point to path dependence, arguing that the pre-crisis public endorsement of CRAs made a radical switch too costly (Chiu, 2013; Kruck, 2016). Other scholars stress how CRAs’ lobbying efforts account for meagre reforms (Underhill, 2015). Yet others hold that policy continuity stems from the resilience of policymakers’ pro-market beliefs (Pagliari, 2012). Despite their differences, these explanations all assume that the key obstacle to fixing ratings’ systemic problems is regulators’ unwillingness to do so. The normative implication is that regulators have failed to implement reforms conducive to the public interest. I argue, in contrast, that limited reforms do not stem from regulators’ unwillingness – but rather their inability – to fix ratings’ systemic problems. Regulators have shied away from intrusive reforms for fear that this would make things worse, not better. To make this point, I draw on the social studies of finance (SSF) literature, which demonstrates that risk assessments, including ratings, are performative: rather than merely reflecting risks, they shape them (MacKenzie, 2004; MacKenzie, 2006; Kregel, 2008; Sinclair, 2010; Carruthers, 2013; Esposito, 2013b; Paudyn, 2013; Svetlova, 2012). My key goal is to demonstrate performativity’s regulatory implications, which have so far received comparably less attention in the SSF literature (De Goede, 2004; Coombs, 2016). The argument is that performativity hampers regulators in fixing ratings’ systemic consequences. It implies that what seems to be a desirable cure – public intervention in the substance of risk assessment practices – in fact contributes to, rather than limits the problem. Replacing all rating references in regulation with another risk indicator might merely switch the source of systemic risk to this other indicator. As the main alternatives to ratings are based on market prices, this feedback loop might increase market volatility. Similarly, standardizing rating methodologies, or setting up a public CRA, may reinforce herd behaviour – either because CRAs’ rating actions become more synchronized, or because participants give a disproportionate weight to the public CRA’s assessments. Regulators recognize the limits of what regulation can actually do to fix ratings’ systemic problems, and see no other option but to implement half-hearted reforms. These limits, I argue, ultimately derive from the performativity of risk assessments. To substantiate this argument empirically, I focus on European Union (EU) policymakers’ efforts to tackle the three key issues mentioned above: (1) addressing rating overreliance; (2) regulating rating methodologies; and (3) setting up a public CRA. Building on an analysis of policy documents, public and private position papers, and reporting in the specialized press, I 22 Stellinga show how policymakers have struggled to design effective regulatory approaches. To corroborate my claim that stakeholders are well aware of the problems with fixing these systemic issues through substantive involvement in firms’ risk assessment practices, I also draw on confidential interviews held in Madrid, London, Paris, Brussels and Amsterdam with senior EU representatives of securities markets regulators, banking regulators, CRAs and the EU banking sector (see the appendix for an overview).2 Why focus on the EU’s reform experience? Following the logic of dominant approaches in the CRA literature, the EU should have been especially well positioned to tackle these issues. In particular, the absence of a pre-crisis regulatory framework provided the opportunity to design a ‘correct’ regulatory approach almost ‘from scratch’, with veto players (the CRA lobby) or institutional path dependencies being substantially weaker than in the US (the obvious alternative jurisdiction to analyse). Still, similar dynamics should have hampered reform in the US, and at several points in the empirical section I also illustrate this. It is also important to stress that EU policymakers had, in principle, the legal power to fix these systemic issues. Reducing regulatory reliance on ratings, and setting up a public CRA were both domains where the EU could ‘go it alone’. Moreover, the CRA Regulation (2009) introduced after the crisis required CRAs to comply with European rules before being allowed to issue new ratings for European entities. This implies that the EU had the power to regulate rating methodologies, among other things. In short, the EU had the legal power to address the systemic issues, and according to existing explanations it was likely to do so. This makes it all the more surprising that EU policymakers ultimately struggled to tackle these systemic issues, suggesting a blind spot in these explanations. While the article’s main argument implies that scholars should be careful in dismissing post-crisis reforms as a blatant failure, it should certainly not warrant an uncritical embrace of the status quo. Indeed, if CRA regulation will unlikely prevent future problems, this necessitates a proactive rather than a fatalist policy approach; a point that I will stress in the article’s conclusion. Systemic problems, timid response In the two decades leading up to the financial crisis, credit ratings gained a more prominent role in European financial markets. Their rise to prominence was facilitated by financial globalization and the integration of European capital markets (Brummer and Loko, 2012). The inclusion of rating references in financial regulations was a contributing factor (McVea, 2010).3 Despite these developments, the EU refrained from regulating CRAs, trusting on US regulation and CRAs’ voluntary compliance with the International Organization for Securities Commissions Code of Conduct instead (IOSCO, 2004; EC, 2006).4These regulatory frameworks mainly addressed internal governance and transparency issues, in order to protect investors from being duped by CRAs’ potential conflict-of-interest problems (Brummer and Loko, 2012). The financial crisis, however, exposed systemic problems. Widespread reliance on apparently dubious ratings issued by a small number of CRAs had contributed to the herd behaviour that led to the build up and materialization of systemic risks (Sy, 2009). Policymakers agreed that ratings’ systemic problems necessitated a fundamentally different regulatory strategy. While integrity problems had surely played a role in the structured finance debacle, regulators acknowledged that the problem was bigger than CRAs’ perverse incentives (White, 2010; Coffee, 2011; US Permanent Subcommittee on Investigations, 2011; cf. Kruck, 23 Finance and Society 5(1) 2016: 4). This assessment was buttressed by the onset of the Eurozone sovereign debt crisis. As sovereigns generally do not pay to get rated, CRAs’ actions could hardly be explained by their issuer-pays business model. The problem was more fundamental: widespread reliance on a small set of risk indicators had contributed to systemic risks. These problems partly stemmed from the methodologies used by CRAs, both in terms of their individual methodologies as well as their general rating approach (Sy, 2009). In particular, CRAs’ structured finance methodologies proved to be flawed in a number of ways: they lacked long run data on default risks for structured finance products; they missed the deteriorating quality of the underlying asset pools; they were too sanguine about the US housing market and correlations between defaults; and they erroneously supposed that risk probabilities followed a normal rather than a ‘fat tail’ distribution (CGFS, 2008; FSA, 2009a). Observers criticized CRAs’ general risk assessment approach – their attempt to rate ‘through the cycle’ – for being slow to respond to changing market conditions, while overshooting once problems seemed evident (Deb et al., 2011). Systemic problems also went beyond the dominant CRAs’ rating approaches to include market participants’ overreliance on their ratings. Investors herded into highly rated structured finance securities, leading to the build up of systemic risks (FSF, 2008). Herd behaviour was stimulated by the inclusion of ratings in regulations, most notably in the Securitization Framework and the Standardized Approach to credit risk of the Basel II accord, and in asset management contracts (Sy, 2009). Widespread overreliance on ratings ensured that downgrades and fire sales reinforced one another in vicious downward spirals. Finally, the sector’s oligopolistic structure, and CRAs’ homogeneous rating actions, ensured that everything collapsed simultaneously (Deb et al., 2011). While stability risks stemming from inadequate methodologies, market overreliance, and rating homogeneity had been recognized before, policymakers had so far been cautious to address them. Given the magnitude of the problems, one would expect the crisis to trigger a bold regulatory response. Critics pleaded for substantive remedies, urging policymakers to take control over firms’ risk assessment practices. They argued for abandoning regulatory reliance on ratings (Partnoy, 2009; Kruck, 2011), setting up a public EU CRA to increase diversity in the rating sector (Bofinger, 2009), and introducing public control over ratings methodologies (Underhill, 2015). Actual reforms, however, failed to live up to these expectations. EU policymakers have only very moderately reduced regulatory reliance on ratings (Kruck, 2016). They have hardly tackled CRAs’ methodology failures and have avoided regulating their content (Paudyn, 2015; Underhill, 2015). And the EU refrained from setting up a public CRA, enabling the continued dominance of the Big Three CRAs and a corresponding lack of ratings diversity (Schroeder, 2015). To be sure, there has been regulatory action. The EU abandoned its hands-off approach and adopted a Regulation (CRA 1) in 2009 (Quaglia, 2013). These rules require CRAs to rotate analysts frequently, prohibit them from mixing consultancy and rating services, and ban analysts from rating an entity in which they have an ownership interest. The Regulation introduces procedural requirements for rating methodologies, and requires CRAs to be transparent about potential conflicts of interest and their procedures to ensure high quality ratings (García and Ruiz, 2012; Pagliari, 2012). It was amended in 2011 (CRA 2) to entrust the newly created European Securities and Markets Authority (ESMA) with the authority to register and supervise CRAs. The Eurozone debt crisis triggered a third amendment, finalized in 2013 (CRA 3). Among other things, CRA 3 introduced procedural requirements for sovereign debt ratings, introduced a civil liability regime for CRAs, and obliged market participants not to rely on ratings in a mechanistic manner (see Chiu, 2014, for an extensive discussion of these measures). 24 Stellinga Still, these regulatory solutions mainly consist of governance requirements aimed at addressing CRAs’ integrity issues. In contrast, reforms aimed at tackling systemic problems have been limited, and policymakers have avoided becoming prescriptive on the substantive aspects of firms’ and CRAs’ risk assessment approaches. Instead, they encourage firms to consider other risk indicators, in addition to ratings, when deciding on investment strategies, and check CRAs’ procedures for the development, application, and revision of methodologies. This policy outcome is surprising: after all, the systemic issues were the most pressing problem, and substantive measures seemed an obvious remedy. What explains this? The post-crisis CRA literature provides various explanations. Ideational accounts focus on changes in policymakers’ regulatory beliefs (Pagliari, 2012). The argument is that pre-crisis pro-market ideas have been much more resilient than many expected. Regulators could attribute rating failures to misaligned incentives – a framing that chimes perfectly well with pre-crisis policy precepts (Mügge, 2011). Private interest accounts, in contrast, argue that successful opposition from vested interests – the dominant CRAs – has hampered more fundamental reforms. While regulators set out to fix rating flaws by designing rules conducive to the public interest, they were led astray by particularistic interests (or so the argument goes, see Underhill, 2015). Finally, the institutionalist perspective – arguably the dominant approach – argues that the lack of fundamental reform stems from path dependence (see Moschella and Tsingou, 2013). Despite CRAs’ obvious mistakes, regulatory reliance on ratings has made public and private actors structurally dependent on CRAs’ risk analyses. Lacking the required risk assessment expertise and capacity themselves, policymakers have found it too costly to revoke CRAs’ earlier granted quasi-regulatory status (Chiu, 2013; Menillo and Roy, 2014; Kruck, 2016). These perspectives highlight important facets of post-crisis regulatory politics. Yet they share an assumption that I argue is unwarranted – namely, that the key obstacle to fixing ratings’ systemic problems is regulators’ unwillingness to do so. This rests on a flawed notion of ratings in which they are treated as reflections of an objectively existing entity called ‘risk’, which the CRAs constantly get wrong. The implication is that if only regulators were willing to implement the proper rules, or if they would develop capacity to measure risks themselves, we would no longer suffer from CRAs’ blunders (cf. Kruck, 2016). Yet a different take on risk assessments, drawn from the social studies of finance (SSF) literature, makes this assumption highly questionable. In particular, the concept of performativity throws doubt on the idea that bold regulatory actions – such as the full removal of ratings from regulation, standardization of rating methodologies, or regulators issuing risk assessments themselves through a public CRA – would contribute to financial stability. In fact, the opposite might be the case. The regulatory implications of performativity Rating performativity The financial system is a reflexive system. Market participants’ assessments of the system’s functioning shape its functioning, in turn affecting participants’ assessments. Put differently, the two-way feedback loop between assessments and outcomes ensures that the system changes under observation (Soros, 2008; Beinhocker, 2013; Bronk, 2013; Esposito, 2013b; Mügge and Perry, 2014). This implies that financial markets have no firm anchor outside of actors’ assessments, despite repeated appeals to fundamental values in the so-called real economy (Keynes, 1964 [1936]; Minsky, 2008 [1986]). Reflexivity thus refers to a general attribute of the financial system: assessments affect the system’s functioning, and vice versa. 25 Finance and Society 5(1) The SSF literature has done much to improve our understanding of which and whose assessments matter, as well as how these affect the system. MacKenzie’s (2004; 2006; 2011) seminal contributions focused on the ‘performativity’ of financial theories. Drawing on Callon (1998), he asserted that these theories, rather than passively recording an external reality, may act as an “active force transforming its environment” (MacKenzie, 2006: 12). If a model has a high academic standing and is publicly available, market participants may start using it. The model then affects economic processes, but may do so to different degrees. ‘Barnesian performativity’ and ‘counterperformativity’ are the strongest forms. The first occurs when actors’ actions lead to outcomes that confirm the financial model’s assumptions: the world becomes more like the model. Counterperformativity is the opposite: over time, actions lead to outcomes that conflict with the model’s assumptions (MacKenzie, 2006; Bronk, 2013). SSF scholars have not confined the study of performativity to financial theories, but have focused on a variety of market practices and models. Credit ratings are an important example (Esposito, 2013a; 2013b). Ratings can exert a key influence on financial market functioning due to several ‘felicitous conditions’ (Svetlova, 2012). First, ratings are visible: the assessments are available for all to see, and the symbols are relatively easy to understand. Second, and relatedly, they are widely used, in part because of their inclusion in financial contracts and regulations. Third, CRAs’ methodologies ensure ratings are relatively stable over time, making them a reliable focal point for long-term investors. Finally, there is limited diversity in ratings: the Big Three CRAs dominate the sector, and their rating approaches are quite similar. All this increases the chance that market participants’ beliefs converge around CRAs’ assessments, thereby strengthening ratings’ real-world effects (Deb et al., 2011). Widespread reliance on a model will not ensure a strong form of performativity (Svetlova, 2012). Crucially, this depends on market participants’ calculative culture and whether they follow ratings blindly or instead take them with a grain of salt. Yet ratings may be so hardwired into financial markets that individuals or firms act on them even if they consider the dominant CRAs’ ratings to be ‘incorrect’. As Sinclair (2010: 99) puts it, “sceptical individuals have incentives to act based on the assumption that others will use the rating agencies as benchmarks”. Rating reliance thus has a self-enforcing element (Esposito, 2013a). As such, ratings have performative effects: they influence the risks that they supposedly merely describe. Positive assessments trigger easy access to cheap credit, while downgrades can exacerbate the issuer’s financial strains (Kregel, 2008; MacKenzie, 2011; Mügge, 2011; Carruthers, 2013; Esposito, 2013a; Beckert, 2016; see Soudis, 2015 for a critical take). As the crisis made painfully clear, ratings’ real-world effects can contribute to the build up of systemic risk (Sy, 2009) – the risk of a “disruption to financial services that is caused by an impairment of all or parts of the financial system…” (FSB, IMF, and BIS, 2009: 2). When confronting financial innovations (such as structured finance products) or novel market developments (for example, the introduction of the Euro), market participants look for anchor points to help cope with the inherent uncertainty of future outcomes (Bronk, 2013: 346). CRAs’ optimistic assessments about particular asset classes or financial innovations can then become self-reinforcing, contributing to behaviour that in turn validates these assessments (Barnesian performativity). But as Minsky already pointed out, this self-reinforcing beliefbehaviour-belief feedback loop raises the fragility of the system, even though it appears increasingly stable (Borio, Drehmann, and Tsatsaronis, 2012). Initial optimism, buttressed by high ratings, has sowed the seeds for subsequent panic. A relatively minor event can be a breaking point, turning a boom into a bust (Gerding, 2014). Rating downgrades and fire sales then reinforce each other in downward spirals (Sy, 2009). Financial markets’ reflexive nature thus implies that theories, models, and valuation techniques can be performative, making the 26 Stellinga world more similar to (or more different from) the initial assessments. We can thus think of performativity as a special facet of reflexivity more generally, as ‘reflexivity in overdrive’. Regulators’ struggle with performativity Reflexivity and performativity introduce specific challenges for public policymakers. While market reflexivity is the general context in which they have to design policies conducive to financial stability, the performativity issue looms large when developing and implementing rules for specific valuation routines, including the issuance and use of credit ratings. Can regulators ensure that these routines have benign performative effects? And what regulatory strategy is most suitable in this regard? While the SSF literature has done much to demonstrate that valuation routines and models shape rather than reflect financial markets, it has so far paid less attention to performativity’s regulatory implications – and how regulators deal with these (Coombs, 2016; Stellinga and Mügge, 2017; Kranke and Jarrow, 2018). For example, while both De Goede (2004) and Paudyn (2015) discuss global regulators’ embrace of private sector risk practices, they appear to dismiss the possibility that regulators recognize potential undesirable effects and the dilemmas associated with the various policy options. The literature mostly treats regulation as an exogenous factor, although this has more recently been changing. For example, Coombs (2016) tentatively concludes that particular regulations – in this case, those aimed at financial algorithms – can ensure benign forms of performativity. Similarly, Langley (2012) shows how US regulators’ financial stress testing exercises were intentionally and successfully performative. This article contributes to the above shift in emphasis by focusing on how regulators deal with problems pertaining to the performativity of valuation tools. The upshot is quite sobering: banking and securities market regulators struggle to find solutions to credit ratings’ systemic effects. On the one hand, regulators hope that CRAs contribute to financial stability by providing relatively accurate risk assessments and allowing market participants to take precautionary measures. Indeed, regulators require banks, pension funds, insurers and asset managers to use ratings mainly to ensure prudent investment behaviour. On the other hand, they dread ratings’ systemic consequences (Sy, 2009). But while it is clear that these problems exist, it is not obvious what regulators can do to fix them. The key problem is that what at first sight seems like a suitable regulatory approach – bold actions aimed at the substance of CRAs’ and firms’ risk assessment approaches – might be a cure worse than the disease. Put differently, regulators fear that sweeping reforms will either reinforce ratings’ systemic effects, or that they will merely shift these destabilizing consequences from one set of risk indicators to another. To be sure, my goal is not to demonstrate that regulators think in terms of concepts such as ‘reflexivity’ and ‘performativity’. Instead, I want to show that they recognize the underlying point – risk indicators influence risks – and that they see this as an obstacle when designing rules conducive to financial stability. It does not matter whether regulators talk about ‘the systemic risk of ratings’, ‘procyclicality’, or ‘rating performativity’. What matters is that they acknowledge that the reason why ratings are potentially destabilizing is also the reason why fixing it through regulation is inherently difficult. The next section shows that regulators see no way to solve this problem, leading them to implement half-baked reforms. Before doing so, I outline the reasons why performativity limits attempts to curtail the systemic effects of ratings. First, performativity hampers regulators in tackling rating overreliance. It is clear that 27 Finance and Society 5(1) regulatory reliance on ratings has severe downsides: it stimulates an automatic market response to rating changes, and other market participants’ anticipation of this effect can set off destabilizing feedback loops. But replacing ratings with other risk indicators may be equally if not more problematic. If this reinforces market participants’ blind reliance on other, more volatile indicators, the problem might become worse. The solution of increasing firms’ discretion in risk assessment procedures also has downsides, especially for systemically important financial firms that tend to neglect long term solvency in order to gain short term profits or competitive advantage. In such circumstances, abandoning micro-prudential stringency is unattractive (Mügge and Stellinga, 2015). Yet even if regulators were able to reduce regulatory reliance, the systemic effects of ratings would persist. Market participants’ use of ratings is not reducible to regulatory requirements. Although regulators can stimulate firms to rely on a variety of risk indicators, preventing them from using credit ratings is wellnigh impossible, let alone desirable. An outright ban on rating issuance has many downsides, not least in that it could contribute to uncertainty and market stress. Performativity similarly makes regulatory intervention in rating agencies’ methodologies problematic. Because methodologies shape ratings, they clearly warrant regulatory attention. But regulators are not necessarily better at identifying appropriate methodologies than CRAs. Consider the main critique of CRAs’ methodologies: they lead to ratings that are slow to respond to market signals (Partnoy, 2009). CRAs aim to rate ‘through the cycle’ (TTC), meaning that ratings are usually relatively stable, contributing to their popularity among investors, thereby boosting their performative effects. But this also means that stress levels can be building up for some time before CRAs finally reconsider their ratings, meaning that downgrades are usually abrupt and substantial (Gonzales et al., 2004; Dittrich, 2007; Deb et al., 2011). This was the case in the Asian debt crisis of 1997-8, the subprime crisis of 2007-8, and the Eurozone debt crisis of 2010-2. But does this buttress the case for a regulator’s prescribed shift to the alternative, ‘point in time’ (PIT) approach, that more quickly translates changing market signals in risk estimates? Not necessarily. Ratings would still have performative effects, but PIT-estimates’ volatility during market turmoil could lead to even worse forms of instability (Gonzales et al., 2004; Hunt, 2009). As regulator approved or prescribed methodologies are not necessarily better than those of CRAs, policymakers have good reasons to avoid substantive involvement. More importantly, prescribing methodologies could aggravate the problem it was meant to solve. Public vetting of methodologies could suggest ratings are officially approved, further bolstering market participants’ reliance on them. And as ratings’ systemic effects partially derive from the dominance of the Big Three CRAs, standardizing methodologies would increase ratings’ homogeneity, thereby worsening the herding problem. More diversity in ratings seems a promising way to mitigate the herding problem. As systemic crises are often the result of a lengthy period of “cognitive myopia” (Bronk, 2013: 348), limiting rating homogeneity is one way to address this. But this strategy is also fraught with difficulties. Given the systemic relevance of the ratings produced by the Big Three, it is unlikely that smaller competitors employing different methodologies could by themselves provide a sufficiently strong counterweight, if only because their assessments would not remain unaffected by the Big Three’s actions. This seems to warrant setting up a public (or publicly sponsored) CRA. But while this might be a quick way to introduce a ‘new voice’, there is a danger that this voice might be heard all too well. Market participants might rely exclusively on the public CRA’s assessments, seeing highly rated financial instruments as publicly approved investments. By inducing herd behaviour, this would reinforce systemic risks rather than mitigate them. 34 Stellinga purposes” (ECB, 2011: 7). Governments publicly responding to the EC consultation (including the UK, France, and the Netherlands) warned of significant downsides to a public CRA. What was the problem? Regulatory capacity was certainly not the most fundamental obstacle. As policymakers acknowledged, public sector bodies such as the ECB had intimate knowledge of the financial positions of sovereigns. Moreover, the ECB and various other EU central banks already had risk assessment departments (see EC, 2015). CRA lobbying also fails to explain policymakers’ hesitation – they were clearly divided on this issue. So where did this hesitation come from? While politicians hoped to quickly increase the sector’s diversity, policymakers realized it was more likely that the public CRA would either attract too little or too much attention. If it was ignored because of being tainted by the “image of political interference” (Netherlands Ministry of Finance, 2011: 10), it would be a waste of money and fail to increase diversity. If, on the other hand, the EU CRA’s ratings were seen as official stamps of approval on sovereign debt, it could lead to herd behaviour around these indicators. According to a banking representative, this latter danger was most pronounced if the ECB were to rate sovereign debt: “If you have the ECB issuing ratings, why would anybody still listen to S&P? Why would you still listen to Fitch? Then you would have the ECB saying what is rubbish and what is not. So I can imagine this would have systemic effects on the markets” (Interview 11). An EU CRA would not solve the performativity problem, but could in fact lead to a worse variant. And so despite major dissatisfaction with the sector’s oligopolistic structure, key public actors backed down. In this context, the EC (2011b) did not propose setting up a public CRA, expressing scepticism regarding the feasibility thereof (EC, 2012). But several fractions in the EU Parliament (EUP) seemed unshaken by the objections and kept the idea alive. EUP Vice President Pitella wanted further investigation of the feasibility of a European agency, such as the European Court of Auditors or the ECB, issuing sovereign ratings (EurActiv, 2011). EUP Rapporteur Domenici also tabled the idea (European Parliament, 2012). A compromise seemed possible – the EU could (financially) support a European private agency. An EUP Motion in November 2011 had already called on the EC to investigate this possibility. This option also did not gain sufficient support, but now for fear that it would not get enough attention. A failed initiative in Germany had not boosted confidence. In July 2011, the consulting firm Roland Berger tried to set up a private rating agency that would be funded by both private and public actors, but it failed to gather enough financial support from issuers and banks (Der Spiegel, 2012). It thus asked the German government for assistance, but was turned down. This failure resonated in the EU, challenging the idea that a private European CRA would (eventually) be successful and making it unappealing to fund such an endeavour with taxpayers’ money (Interview 10). The final CRA 3 Regulation (Recital 43) merely obliged the EC to submit a report on the desirability of setting up a public CRA or a European credit rating foundation. According to stakeholders, this was a way to shelve the issue: “the European Commission eventually said ‘we will write a report on it’, which is usually a good way to get the discussion off the main stage” (Interview 9). The subsequently published report (EC, 2015) reiterated the key problem: a public CRA would either duplicate existing information (making it a waste of money), or it would get too much attention (making it potentially dangerous). According to the EC (2015: 18), it entailed “the risk of creating over-reliance on a new alternative if relied upon by investors in an exclusive way”. Ultimately, policymakers did not dare go down that road. Once again, the potentially harmful consequences of a substantive solution limited policymakers’ reform ambitions. The Commission therefore indicated it would not pursue the idea any further. 35 Finance and Society 5(1) Conclusion The global financial crisis made clear that ratings can contribute to the build up of systemic risk. Critics looked at governments to fix these flaws, arguing that regulatory rating references should be replaced by better indicators, that CRAs’ methodologies should be vetted or prescribed, and that a public alternative to the dominant CRAs should be set up. Actual reforms turned out differently, and a substantial gap emerged between the magnitude of the identified systemic problems and the adopted solutions. Policymakers encouraged market participants to use other risk indicators, but they themselves continued to rely on ratings. Regulators introduced procedural requirements for CRAs’ methodologies, but steered clear of prescribing their substance. And the public CRA that many deemed necessary was never set up. Unsurprisingly, there have been frequent accusations that the lack of far reaching reform reflected regulators’ unwillingness to fix these problems, either because institutional path dependencies made it too costly, because regulators feared private sector opposition, or because they were unable to discard pre-crisis regulatory ideas. I have argued, in contrast, that limited reforms stem from regulators’ inability to solve the underlying problems. These regulatory limitations are rooted in the performativity of risk assessments. CRAs cannot help but influence the risks they purport to simply measure, and regulation cannot undo this situation. Moreover, policymakers rightly feared that bold regulatory actions (such as prescribing rating methodologies, issuing ratings themselves, or requiring market participants to use market-based measures instead) would actually make things worse. With this article, I aim to contribute to the SSF literature by showing the value-added of a focus on financial regulation. The analysis shows that regulators are quite aware of the fact that risk assessments may affect the risks they set out to measure, but that they also see how this introduces dilemmas for financial regulation. Similar dynamics might appear in other regulatory domains pertaining to firms’ valuation and risk measurement practices (FSA, 2009b; FSF and CGFS, 2009). For instance, Mügge and Stellinga (2015) have shown how the performativity of accounting standards has led to repeated ad-hoc modifications, both before and after the crisis. Here, the real-world effects of one particular measurement approach inevitably bolster the case for switching to another. Also in other domains – such as rules on risk-weighting assets in financial portfolios, firms’ reliance on quantitative risk models, or stress testing exercises that assess how firms would fare in adverse market conditions – the performativity of risk assessment practices seems a crucial regulatory problem. Examining how regulators deal with this problem seems a promising avenue for future SSF research. The reflexivity of financial markets and, as a consequence, the performative nature of risk assessment, implies that policy problems may show a much greater resistance to effective solutions than we often assume. But this certainly does not mean that regulation is futile. An SSF perspective on financial regulation that solely aims to expose regulatory failures risks being merely “complicit with anti-regulatory rhetoric” (Coombs, 2016: 297). My sobering conclusions should therefore inspire alertness rather than nihilism, heightening the urgency of regulatory efforts to prevent analytical monocultures. Performativity can contribute to systemic crises when “all actors come to share the same or similar beliefs, narrative or modelling framework” (Bronk, 2013: 346). To spot anomalies and potential sources of systemic risk, we need institutionalized ‘self-doubt’ – organizations that provide alternative narratives to dominant conceptions of benign market developments. This may go some way in tempering future ‘this-time-is-different’-delusions. Yet the perspective on financial market functioning presented in this article highlights the limits to containing systemic risks solely through financial regulation aimed at firms’ valuation 36 Stellinga practices (Warwick Commission, 2009; Mügge and Perry, 2014). This suggests that complementary policy strategies are needed to limit the damage that finance can do. Crucially, it suggests a critical re-evaluation of policies that contribute to the credit-intensity of our societies, for example tax incentives that favour debt over equity finance. It may also take the form of more direct policy measures, such as ceilings on credit growth and rules on credit allocation (Turner, 2015). Such measures could be part and parcel of an ambitious macroprudential policy strategy – or in any case, something more ambitious than the macroprudential policies actually implemented after the crisis (Baker, 2018). Even if this will not prevent crises, reducing our debt dependence will at least ensure that potential problems will be more limited in scope. Finally, acknowledging financial markets’ inherent instability also points at the limits of a narrow policy focus on financial stability alone. It forces us to ask the social purpose question of finance: What role do we want finance to play in our societies? Understanding finance as inherently destabilizing will generate more scepticism about the desirability of debt-fuelled growth than understanding it as self-stabilizing. This highlights the desirability of developing a broader vision of the place and purpose of finance in society (Baker, 2018). Translating this vision into actual policy reform will require that policymakers look beyond their typical fields – capital requirements, monetary policy, tax policies – in order to address the issue of policy coherence and coordination. If we see our economies as ‘inherently financial’, then we should reassess the idea that policy fields should only have one policy goal, as has become the norm since the 1980s. Informed by a broader notion of the social purpose of finance, policymakers should critically evaluate whether different policies are conducive to the broader social role envisaged for finance (Mügge and Perry, 2014). Acknowledgments This research was supported by the Horizon 2020 programme of the European Union through the ENLIGHTEN project (649456). I am grateful to the participants of a workshop at the DutchBelgian Political Science Conference in June 2016 for their helpful comments. I would also like to thank the participants of a joint workshop, in October 2016, of the political economy research institutes of the University of Sheffield (SPERI) and the University of Amsterdam (PETGOV); Marieke de Goede and Daniel Mügge at the UvA; and the reviewers and editors at Finance and Society for their comments and suggestions. Finally, I wish to thank my interviewees for their willingness to help me with this research. Notes 1. A credit rating is an indicator of a CRA’s assessment regarding the creditworthiness of a particular entity (such as a firm or a government) or a particular obligation (such as a structured financial security), expressed using a ranking system. Ratings are meant to assess the probability of defaults or losses for investors. 2. To ensure confidentially, I have not disclosed the specific agencies the respondents work for. 3. While in the run-up to the crisis the EU still did not match the US’s rating reliance, it was definitely catching up (Menillo and Roy, 2014). Parts of the Basel II capital adequacy accord (2004), specifically the Securitisation Framework and the Standardised Approach to credit ris, used assets’ credit ratings to calculate capital requirements (Weber and Darbellay, 2008; Alexander, 2014). Ratings also informed the European Central Bank’s assessment of banks’ collateral in refinancing operations (ECB, 2008), thereby stimulating banks to pay attention to their assets’ credit ratings. 37 Finance and Society 5(1) Finally, national authorities used ratings (albeit only limitedly) in investment fund regulation (FSB, 2014; García and Ruiz, 2012). 4. The European Commission had actually championed a system of monitored self-regulation, requiring the Committee of European Securities Regulators to check CRAs’ compliance with the IOSCO Code of Conduct (EC, 2006; IOSCO, 2004). This Code contained certain requirements on internal governance and information disclosure, but the bar was so low that the Big Three CRAs were thought to comply with them already (CESR, 2006). And while European rules required banking supervisors to assess some aspects of CRAs’ conduct, the EC (2006) admitted that in practice this measure too fell short of regulating CRAs (Sy, 2009). 5. Apart from the European Securities and Markets Authority, these are the European Banking Authority and the European Insurance and Occupational Pensions Authority. Appendix: Interviews Interview 1: Banking regulator (two respondents); 16 March 2016 Interview 2: Securities market regulator; 4 April 2016 Interview 3: Securities market regulator (two respondents); 8 April 2016 Interview 4: Securities market regulator; 8 April 2016 Interview 5: Banking regulator (two respondents); 13 April 2016 Interview 6: Credit Rating Agency representative (two respondents); 13 April 2016 Interview 7: Credit Rating Agency representative; 14 April 2016 Interview 8: Banking and investment services representative; 14 April 2016 Interview 9: Securities market regulator; 21 April 2016 Interview 10: Credit Rating Agency representative; 22 April 2016 Interview 11: Banking sector representative; 3 June 2016 References Alexander, K. (2014) The risk of ratings in bank capital regulation. European Business Law Review, 25(2): 295-313. Beckert, J. (2016) Imagined Futures: Fictional Expectations and Capitalist Dynamics. Cambridge, MA: Harvard University Press. Beinhocker, E. 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