Monday, April 26, 2010

Solving The Credit Ratings Agency Problem

Paul Krugman discusses the problem of rating agencies (Which I have discussed for example here, here and here).

The problem isn't just incompetence, but also the problematic incentives created when issuers of bonds choose between the agencies, meaning that rating agencies often have strong incentives to give higher ratings than they know are proper, since they will otherwise lose the customer. Another problem is that their assessments when "correct" are only "correct" because of the self-fulfilling prophecy mechanism. Two equally sound institutions may end up differently only because one received high ratings and thus had easy access to capital, while another suffered a failed due to liquidity problems created because they received low ratings.

Allowing people to sue rating agencies for ratings which are purposely manipulated and non-objective is a fine principle and should be implemented. However, because rating agencies can likely afford to hire very good lawyers, this will not always be effective.

Krugman's favored solution is for the government to choose rating agencies. But a better solution would be for bond purchasers to choose agencies.

Furthermore, all legal privileges for rating agencies should be abolished. I am here referring to the legal requirement on or encouragement of many financial institutions to use credit rating agencies. If governments didn't require or encourage their use, they would be forced to shape up to attract business.