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Reforming Bond Rating Agencies: NYT Misses the Boat
One of the factors that allowed for the proliferation of garbage finance in the bubble was the fact that bond rating agencies were willing to give investment grade ratings to complex financial instruments that they did not understand. They had incentive to do this because they were being paid by the banks whose junk they were rating.
The NYT correctly points out that the Obama plan does not change this "issuer pay" system for the rating agencies. For some reason it doesn't discuss the most obvious reform: simply changing who picks the rating agency.
If the rating agency was selected by someone other than the issuer, for example the stock exchange that lists the company's stock, then the rating agency would no longer have incentive to bias its rating, since the issuer would not control whether it could be selected for future business.
Changing the party who selects the rating agency is much simpler than changing the party who pays, since it doesn't involve any money. (There would be a trivial amount of money needed to run a bond-rating agency assignment desk.) It is peculiar that the NYT did not discuss this obvious reform of the current system.
--Dean Baker
COMMENTS (2)
Certainly there is a bias in favor of high ratings if the issuer chooses the ratings company, but I don't see how having the exchange make the choice eliminates all bias. Don't exchanges want the stocks they list to have high and growing prices, and aren't bond ratings of a company a major factor in its stock price?
This seems to be an example of why markets are not self-regulating - in reality there are many factors which cause stocks to be overpriced and bonds to be overrated (at times anyway). Having a government agency do the ratings could be part of a real reform package.
One reason why the biases exist is because current salary and tax structures allow those in power to make a fortune in the short term. Misratings and tricks to puff up stock price may be bad policy in the long term, but CEOs don't have to worry about the long term.
Posted by: skeptonomist | June 18, 2009 10:19 AM
The regulatory reform proposals are all clouded by the same fundamental error that has allowed the greatest financial fraud in US history to occur.
The assumption that firms and regulators have an underlying integrity and that the "honor system" will prevent them from stealing is a fundamental error. The best lesson learned from the Great Depression ; It hasn't and it won't. Regulation should be designed to prevent the opportunity for theft. The lack of serious reform of the rating agencies is a huge hole in the OB approach.
Posted by: zinc | June 19, 2009 8:09 AM