Vincent Fabié

Revamp the business model of credit rating services: We must interpose an independent third-party between issuers and rating agencies to overcome inertia in rating agencies reform — before free-marketers take advantage of the current crisis to promote deregulation approaches.

Everyone knows that we are in the midst of the worst credit crisis since the early 1930s. But what the casual observer may not know is that the system set up to protect investors is flawed to the core. The current crisis was driven, in part, by erroneously positive ratings of bonds backed by subprime residential mortgages. At the heart of the problem is the role of rating agencies and rating-driven regulations. These regulations determine how much capital certain institutions (e.g., insurance companies, banks) need to have available in order to own financial instruments. The safer the investment (i.e., the lower the probability of default), the less capital is required. Consequently, how an investment is rated determines how much capital a regulated institution such as a bank needs on hand. Thus, rating agencies have a profound influence on institutional investments – so profound that the rating agencies are the de facto allocators of capital in our system.

Policy-makers continue to appeal for a critical review of rating services, and some commentators now advocate removing rating-driven regulations entirely. They consider that the problem in the recent crisis was not the wrong ratings in itself but the fact that these ratings were incorporated into law through rating-driven regulations. In this conception, regulators should not have relied on ratings agencies to assess the risk of bond holdings but on markets that would be a better judge of risk and value than any analyst or company. Read the rest of this entry »