A Simpler Fix for Ratings Agencies
May 14th, 2010 - 1 Comment
“The Senate approved a provision that would thrust the government into the process of determining who rates complex bond deals, in a move to end alleged conflicts of interest blamed by some for worsening the financial crisis,” The Wall Street Journal reports. “The amendment aims to resolve what’s considered one of the thorniest problems in financial markets: Bond issuers choose ratings agencies and pay for ratings, meaning raters’ revenues depend on the very firms whose bonds they are asked to judge. Under the new provision, the Securities and Exchange Commission would instead establish and oversee a powerful credit-rating board that would act as a middleman between issuers seeking ratings and the rating agencies.”
Years ago, Smeal’s J. Edward Ketz proposed a much simpler way to remedy this conflict of interest in a manner that doesn’t establish an entirely new regulatory scheme. From a 2008 Ketz column on SmartPros.com:
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The fundamental problem with credit ratings is the conflict of interest caused by the issuer’s paying the rating agency. Because such a conflict of interest exists, various potential problems surface since employees—in particular managers and analysts—know how they are compensated. Even if the credit rating agency is smart enough to avoid direct linkages between compensation and ratings, there nevertheless is an association. All employees know that their continued employment, their salaries, and their promotions depend upon their contributions to the real business of the organization.
… The real solution is simple and existed prior to 1970. Require the credit rating agencies to charge the users of its information instead of charging those they investigate. The conflict of interest is completely removed. Not only that, but you reinstate a market mechanism: If the users really want the information, they will pay for it. And if the market has sufficient competition, the price will be the value of the information.