SUPER DISCLOSURE: THE FLAWED CREDIT RATING REGULATORY REGIME
Recently introduced legislation such as the Dodd-Frank Act and EU Directives has intensified the regulation of credit rating agencies by increasing mandatory disclosure requirements, creating a "super disclosure regime." Although this regime effectively raises barriers to entry for new rating agencies globally owing to extraterritoriality, it fails to address a critical problem: the continuing mismatch between the industry-standard design of credit ratings, which de-emphasizes volatility, and investor expectations. The rating process, once analytically dissected and empirically compared against benchmark measures that are more sensitive to systematic risk and systemic risk, is shown to exhibit behavior resulting in a continuing vulnerability of the financial sector to cascading downgrades during unforeseen periods of stress. The appropriate answer to this problem is not to continue enhancing disclosure requirements, but to require rating agencies to assign an additional stressed credit rating that reflects how the rating would change under stress conditions, at minimal incremental cost. A unique legal analysis of actual ratings disclosures of three banks which failed in 2008 due to volatile market conditions reveal that the agencies were already materially compliant with multiple disclosure requirements, whereas an additional stressed rating might have helped investors grasp the uncertainties underlying these ratings and mitigate the mismatch problem.