Good Intentions Gone Awry: A Policy Analysis of the SEC's Regulation of the Bond Rating Industry

This paper discusses the SEC's regulation of the bond rating industry. Until a few years ago this specific branch of SEC regulation was largely unknown outside the agency and the bond rating industry itself, even among knowledgeable Washington insiders. But the SEC has actually regulated the industry since 1975: by limiting entry, in an indirect but powerful way. As a consequence, incumbent bond rating firms are protected; potential entrants are impeded; and new ideas and technologies for assessing the riskiness of debt, and thereby the allocation of capital, may well be stifled. This entry regulation is an excellent example of good intentions having gone awry, via the "law" of unintended consequences. The good intentions were to improve the safety-and-soundness regulation of financial institutions, and even to use "market" information to do so. But the unfortunate result has been a distortionary entry restriction regime with respect to bond rating firms. Fortunately, there are better ways to achieve the desired goals – ways that would permit the SEC to cease these entry restrictions and nevertheless allow safety-and-soundness regulation of financial institutions to proceed in desirable directions. If the SEC were to exit from its role as the entry regulator of the bond rating industry, financial markets’ participants could then make their own decisions as to which firms and methods offer the best information as to the default probabilities and other relevant parameters with respect to debt issuances. This paper expands on these themes.