The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed federal financial regulators to remove credit ratings from their rules, but had nothing to say about the use of credit ratings by state insurance regulators. This omission is significant because insurers own nearly twice as many foreign, corporate, and municipal bonds as banks do. During the 2000s, state insurance regulators came to rely increasingly on rating agencies rather than the regulators’ in-house valuation office to assess the credit risks of these holdings. After the perceived widespread failure of ratings in the crisis, the insurance regulators did undertake a review of their use of ratings in regulation. This review, which has been going on for over two years, does not seem to be on a path to eliminate the use of credit ratings in insurance regulation. The one decisive action regulators have taken in this area, ceasing reliance on credit ratings on mortgage-backed securities in favor of a standard more favorable to the industry, seems to be an example of what I call a "rule bailout"—an ad hoc regulatory rule change to benefit a struggling industry during a crisis. The increasing dependence on outsourced credit ratings under industry pressure during a boom, rule bailout during a crisis, and subsequent reconsideration of the use of credit ratings suggests a political cycle of financial regulation, in which significant reform is feasible only in the aftermath of crisis. This cycle complicates several leading technical proposals for improving capital regulation and may limit what we can expect from the project of financial regulation generally.


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