Regulating financial markets with financial knowledge

Knowledge produced in financial markets is not only used by market actors themselves, but also by financial market regulators, like the US Securities and Exchange Commission or the European Commission. One example for the use of financial knowledge in regulations are credit ratings produced by rating agencies like Standard&Poor’s and Moody’s. Credit ratings have been used in many regulations to set minimum capital requirements for banks, or regulate institutional investors and other financial market actors. Since the harsh criticism of rating agencies that followed the financial crisis, the US and the European Union have started massive financial regulatory reforms concerning the role of rating agencies and their credit ratings. In this paper I argue that these reforms, while aiming at preventing conflict of interests, fraud, and other criminal behavior of rating agencies, focus too much on the individual rating agency. The reforms neglect more systematic problems, like differing and competing rating methodologies and assumptions within rating agencies, or contradictions between their First Amendment protection and the regulatory use of ratings. Using comments on proposed rules and interviews with credit rating analysts and other experts, this paper addresses these issues and raises questions concerning the outsourcing of regulatory power to financial market actors.