“You Can Have the Cake and Eat It” the Role of Ratings in Collateral-Based Financial Systems

The financial crisis brought the main function of “shadow banking” arrangements to the fore quite bluntly—“you can have the cake and eat it” by providing liquidity and safety at the same time. Banks’ liabilities to non-bank entities can be read as one proxy for the interconnectedness of traditional and shadow banking system. This interplay is regarded as relatively unproblematic as long as the collaterals, which back repos, are regarded as liquid and safe. Thus the construction of collaterals used for private repo transactions is the conditio sine qua non for the shadow banking to perpetuate itself. In this article, I analyze the role of CRA ratings in collateral-based financial systems, with a special emphasis on sovereign ratings as eligibility criterion for sovereign bonds as collaterals in the private European repo markets. What is the function of CRA ratings in the construction of the ‘liquid and safe’-formula? Moreover, the paper focuses on the ECB to address the question of how the epistemic authority of CRAs in terms of sovereign creditworthiness is “constantly being both constructed and worn away” by the collateral framework of central banks. It asks to what extent do collateral requirements for central bank repos and collateral eligibility standards in private repos, i.e. market practice, influence each other? If ratings co-constitute the eligibility of sovereign bonds as collaterals, then sovereign rating downgrades have the potential to drain the liquidity on the interbank market, highlighting one crucial dimension of the politics of shadow banking practices.