Credit Rating Agencies & Regulation: Why Less Is More

Name of Publication: 
Make Markets Be Markets

 

The three large US-based credit rating agencies - Moody's, Standard & Poor's, and Fitch - provided excessively optimistic ratings of subprime residential mortgage-backed securities (RMBS) in the middle years of this decade, actions that played a central role in the financial debacle of the past two years.  The strong political sentiment for heightened regulation of the rating agencies - as expressed in legislative proposals by the Obama Administration in July 2009, specific provisions in the financial regulatory reform legislation (H.R. 4173) that was passed by the House of Representatives in December, and recent regulations that have been promulgated by the Securities and Exchange Commission (SEC) - is understandable, given this context and history.  The hope, of course, is to forestall future such debacles.

The advocates of such regulation want to grab the rating agencies by the lapels, shake them, and shout "Do a better job!"  But while the urge for expanded regulation is well-intentioned, its results are potentially quite harmful.  Expanded regulation of the rating agencies is likely to:

  • Raise barriers to entry into the bond information business;
  • Rigidify a regulation-specified set of structures and procedures for bond rating; 
  • Discourage innovation in new way of gathering and assessing bond information, new technologies, new methodologies, and new models (including new business models).

As a result, ironically, the incumbent credit rating agencies will be even more central to the bond markets, but are unlikely to produce better ratings.

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Lawrence J. White is Arthur E. Imperatore Professor of Economics at New York University's Stern School of Business and Deputy Chair of the Economics Department at Stern.  During 1986-1989 he served as a Board Member for the Federal Home Loan Bank Board, and during 1982-93 he served as Director of the Economic Policy Office, Antitrust Division, US Department of Justice.

The views expressed in this paper are those of the author and do not necessarily reflect the positions of the Roosevelt Institute, its officers, or its directors.