Ratings Agencies Without Regulatory Mandates

I liked this NYT masthead overview of the need for ratings agency reform and some options for doing it, but I thought their discussion of the deregulatory option went a little bit astray:

If there is no way to improve raters’ track record, a more drastic step would be to eliminate them, or at least eliminate the legal requirement that some insurance companies, pension funds and other entities hold assets with high ratings, a rule that gives the raters enormous quasi-regulatory power.

This is not a perfect solution. A world with no rating agencies would leave many investors at sea. But it is not much of a life raft if agencies cannot do better than they did during the housing bubble.

It seems to me to be a misunderstanding to think that loosening the regulatory mandates around holding high-rated securities would create “a world with no rating agencies.” As the editorial indicates these agencies exist because there’s legitimately demand for information about the riskiness of investment opportunities. And as I tried to highlight in my primer on the subject if “information about the riskiness of investment opportunities” was your main interest in a ratings agency, then these conflicts-of-interest shouldn’t be a huge problem. The conflicts, after all, are actually pretty well-known and obvious and there are smaller raters out there who don’t have them. But in many cases consumers of high-rated investments aren’t actually especially interested in information, they’re just interested in complying with a regulation that says they need to hold such-and-such quantity of AAA-rated stuff which totally breaks down the market discipline.

That’s not to say totally deregulating this field is necessarily the way to go, but the proposal should be understood correctly one way or the other. The idea isn’t to do away with rating, or with firms in the business of doing ratings, it’s to eliminate the demand for inaccurately rated investment opportunities.