7.15.2009

Must We Regulate to Reform the Credit Rating Agencies?

The SEC is proposing greater regulation of Wall Street credit ratings agencies.


While I think the rating agencies got off remarkably easy in the public mind given their contributions to the economic crisis (perhaps because they're a bit obscure to be a clear target for many), I don't think the SEC effort will do much good.  And even if the push does make rating agencies more responsible, it should not really necessary to have government involvement to achieve the same results.

A credit rating agency's commodity is the accuracy or relevance of its rating of the riskiness of various securities and financial instruments.  When a rating agency fails at that task, as many did in the economic crisis, they should be chastised by the market - the one product they sell failed, so who would rely on them again?  Products that were not top grade products were rated as top grade products.  Sure, the ratings agencies get paid by the issuers of the securities they rate, but the ratings agencies failed to overcome the conflict of interest themselves through some set of rigorous internal mechanisms or screens to ensure accuracy, the root of an agency's existence.

Now, the government is going to prop up ratings agencies that failed by regulating them.

Instead, those rating agencies that came up with the most rigorous internal mechanisms to overcome conflicts of interest with issuers should naturally rise to the top among issuers who want their securities not only to be given a top notch rating, but also a soberly accurate rating to avoid further negative consequences after the fall.  

Investors looking to purchase shares, too, should be pressuring issuers to use higher rating agency standards and insisting on more safeguards to avoid losses before purchasing.  The SEC shouldn't have to intervene if market participants were simply being somewhat smart and self-interested (and they're taking risks backed with their dollars, so they should be held to that standard).  The track records of various rating agencies should determine which rating agencies can actually be trusted to assess the proper amount of risk inherent in a given financial instrument or security.

I understand the populist backlash at work here and the damage done by rating agency mistakes, but I disagree with using regulation as the proper response.