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In 1998 Geoffrey Miller declared “the obsolescence of commercial banking” (1998, p. 61). Due to the trend of disintermediation, Miller concluded that banks were becoming obsolete. As a result of disintermediation banks did indeed see their earnings from traditional corporate finance and savings, as well as deposits decline. But, contrary to Miller’s argument, relative to other financial institutions, banks’ profits have not declined. Banks were forced to seek out new profit-making opportunities. As Euturk and Solari describe, “Things had to change...Banking had to rediscover itself: how it worked, the sort of people it

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needed to employ, how it intended to serve its customers” (2007, p. 369). The centerpiece of this transformation was the process of securitization. Moving away from traditional bank lending practices, banks began to engage in sophisticated financial engineering and the selling of residential debt in secondary markets (Rethel & Sinclair, 2012). Banks became less bank-like.

Beginning in the 1980s banks began finding new profit opportunities by converting consumer debt into tradable securities and then selling those securities on the secondary mortgage market (Blackburn, 2008). This change has been described as a shift from relationship banking -- where banks focus on establishing long-term relationships with clients -- to a transaction-based banking model that aims to

originate and package as many loans as possible in order to earn fees.31 Examining the net income of US

banks, Allen and Santomero (2001) describe a decline in income generated by interest and a corresponding rise in fee-driven income, such as trusts, annuities, mutual funds and transactions services. Moreover, an increasingly large portion of banks’ income is now from the trading of derivatives and securities on their own account (Panitch & Gindin, 2012). Erturk captures this transformation: “Bank branches of the 1970s were dominated by the long counter across which money was paid in and out by bank clerks...In the early 2000s bank branches are dominated by the cubicles and work stations where advisers sell financial service

products like mortgages and pensions” (2008, p. 9).

Under this model banks originate loans for the purposes of pooling them together and selling them

on to other funds and banks (McVea, 2010).32 In this way highly illiquid assets can be converted into more

liquid, tradable and therefore profitable financial instruments. Throughout the Subprime Crisis mortgage securities made up 18% of the debt markets, overtaking US Treasury bonds as the single largest component (FCIC, 2011). Banks transferred such assets into special purposes vehicles (SPV) so as to avoid legal liability

31 _{This shift is also commonly described as a shift from an originate-to-hold model of banking to an originate-to-}

distribute one.

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The American subprime mortgage market is a good example of this process and its dire consequences. Banks originated loans creating residential mortgage-based securities (RMBS), and then pooled them together into collateralized debt obligations (CDOs). Banks then sold these once ‘illiquid’ assets to investment banks, who not wanting to hold onto the risk placed these assets into a special purposes vehicle (SPV) (Rousseau, 2009). The SPV would then be broken up into different tranches or risk levels. The rationale for this process lay in the distribution of risk: by distributing the risk financial institutions were able to offset the risk of potentially destabilizing credit defaults.

in the case of default. Moreover, as SPVs do not fall under the Federal Reserve’s regulatory purview, these activities remain off the balance sheet and banks are not restricted by regulations such as reverse

requirements. This had the distinct consequence of eroding the traditional bank function of prudentially assessing borrowers’ creditworthiness. As banks’ income becomes increasingly fee-driven, their incentive to prudentially assess borrowers’ creditworthiness is significantly reduced. This is seen in the increasing amount of subprime mortgages originated by banks, which reached a high of 23.5% of all mortgages in 2006 (FCIC, 2011). Thus, in seeking to offset losses that resulted from disintermediation, banks have relinquished their role as quasi-public intermediaries.

The process of securitization has led to the proliferation of structured financial products that reached a total value of $9 trillion in 2007 (Coval, Jurek & Stafford, 2009). The growth in such financial products was enabled by the massive expansion of subprime leading -- from 190 billion in 2001 to 600 billion by 2006 – and an increasing percentage of subprime loans being securitized, which grew from 50.4% in 2001 to 80.5% in 2006 (Carruthers, 2010). The growth in securitized financial products was crucial to the growing demand for credit ratings. The rating of structured financial products became the rating agencies’ largest source of income—accounting for 44% of all Moody’s ratings revenue in 2006 (Coval et al., 2009). Between 1999 and 2007 Moody’s revenue from structured financial products rose from $172 million to $891 million—an increase of 415 percent (Hunt, 2008).

Conversely, credit ratings have also been instrumental to the growth of structured finance. Securitization is, and always has been, a ratings-driven product (Hunt, 2009). Products are designed to satisfy the established arbiters of credit quality—the rating agencies. Both tranching and the purchasing of credit default swaps (CDS) are examples of techniques designed to secure higher credit ratings for financial products. Not only are products specifically designed to receive higher ratings, but the rating agencies themselves were involved in the creation of these financial products. They would specify in negotiations the components that would allow a high percentage of the securities being issued to garner AAA ratings (White, 2009). This meant, as MacKenzie notes, “the securities themselves and the knowledge of the security were thus co-produced” (2011, p. 1795). The CRAs did not simply react to changes in financial markets, they

actively contributed to them.

The transformation of commercial banking, along with the global financial environment, has been accompanied by profound changes in information gathering and risk management (Lapavitsas, 2011). The consequences of a transaction-based model of banking are an increase in systemic risk, market uncertainty and the proliferation of highly complex financial products as illustrated by the recent Subprime Crisis. The transformation of illiquid assets into tradable commodities results in massive amounts of liquidity being injected into capital markets, thus greatly increasing the volume of market transactions. Moreover, given the highly complex nature of financial products, financial transactions have become increasingly difficult for an average investor to fully understand (Whiteside, 2006). The emergence of such complex financial

instruments created a growing need for reliable information on risk assessment (Kruck, 2011). As the FCIC states, “This complexity transformed the three leading credit rating agencies...into key players in the process, positioned between the issuers and the investors of securities” (2011, p. 43).

Conclusion

The liberalization and deregulation of national economies has triggered the rapid expansion of global financial markets. Accompanying this expansion has been the radical transformation of the banking and financial industries, as captured by the trends of disintermediation and securitization. These trends have diminished the role of banks as financial intermediaries and heightening the complexity and volatility of financial markets. As a result, CRAs, having the perceived expertise necessary to analyse these complex financial instruments, have emerged to fill the role of the financial intermediary left by banks.

While changes in financial markets have heightened the need for various institutions of credit evaluation, why have CRAs in particular come to dominate this market? And why, given their historical record of failure, are CRAs perceived as having the necessary expertise for a role? CRAs represent one among a number of institutions that produce credit-related information: export rating agencies; credit registers; investment banks; and the financial press are all examples of institutions that provide information on financial risk (Whiteside, 2006). Given the multiplicity of information sources, the idea that there is no

alternative to CRAs in a disintermediated financial environment is problematic. As Dieter Kerwer points out, by focusing solely on economic trends and criteria of market efficiency it is “hard to demonstrate [why] in the face of these heterogeneous sources…rating agencies would be able to effectively monopolise the cognitive constitution of the credit relationship” (2001, p. 6).

A number of constructivist scholars from science and technology studies (STS) have pointed out that technological developments are inherently underdetermined. While there may be a need for certain

technological developments to solve a problem, there are generally a number of workable solutions to that problem. The choice between these solutions is made by actors using social and political criteria (Feenberg, 2010). Thus, while changes in financial markets may have stimulated the need for certain institutions of credit evaluation to develop, the particular form they take, and the power granted to them, remain underdetermined by technical criteria. While changes in financial markets are necessary to discuss, they insufficiently explain why CRAs have been able to consolidate their power amongst alternative and equally viable institutions. In order to correct this limitation, the political and social aspects of CRAs’ power will be explored. As such, the next chapter will discuss the political component of CRAs’ power. It focuses

specifically on how states, particularly the United States, have incorporated credit ratings into market regulations for strategic purposes.