Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice

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ANSWERS TO CHAPTER DISCUSSION QUESTIONS 467

Securities Valuation Office (SVO) illustrates this; the NAIC decided to outsource

most of its evaluative duties to private rating agencies because it was felt that

the SVO duplicates effort.

At the same time, regulators should recognize that regulatory use of ratings

poses a kind of externality in the form of a risk of creating problems for rating-

agency quality. Regulatory use of ratings produces demand for ratings that is

independent of rating quality and thus blunts incentives for high-quality ratings.

It also heightens pressure on rating agencies to inflate ratings and could create

a feedback loop in which rating changes produce defaults. Rating agencies may

not be well-equipped to deal with this endogeneity, and they do not seem to

want this responsibility. For example, S&P has taken the position that ratings

should not be incorporated into financial regulation. Of course, most of these

points apply to purely private “reference uses” of credit ratings such as the

Goldman-AIG trading arrangements.

Regulatory uses of credit ratings that are not tied purely to credit risk are

especially problematic. The SEC’s Rule 15c3-1 for broker-dealers uses high credit

ratings as a proxy for liquidity. The ERISA rules treat a high credit rating as a

proxy for the absence of a conflict of interest between the underwriter and

pension funds with which it may interact. Even if