Less Regulation, Better Credit Ratings?

Overregulating of credit ratings might just have a happy ending.

With rating firms under pressure from policy makers for their failures over complex structured finance ratings, there must be a tipping point at which they would give up their officially sanctioned status to escape the burdens any changes could bring. If that led to no government involvement in ratings and no reference to ratings in laws, the financial world could be a better place.

The Securities and Exchange Commission already approves nationally recognized statistical ratings organizations and is contemplating tightening oversight and regulation further — maybe even making the likes of Moody’s, Standard & Poor’s and Fitch Ratings financially liable for rating errors.

Congress is in the game too, with new draft credit rating legislation circulated last week and two hearings set for Wednesday, one called by the House Oversight Committee, led by Representative Edolphus Towns, Democrat of New York, and one by a House financial services subcommittee. Even the National Association of Insurance Commissioners is taking an interest, because insurance watchdogs also use the rating firms’ credit assessments.

The badge that comes with being nationally recognized goes alongside references to ratings in laws and regulations. Some of the specifics are unique to the United States, but the overall picture is similar elsewhere. The Treasury and others have said that officials globally should work to reduce government and investor reliance on credit ratings. But the moves toward tighter regulation suggest authorities aren’t ready to cleanse the system of ratings just yet.

But it’s just possible to imagine that the big rating firms may do it themselves if they are allowed to, despite the help that the S.E.C.’s seal of approval has given to the market positions, and the profitability, of the big rating firms over the years. For example, if Congress were to approve ideas in the latest draft legislation that insist that raters shoulder significant liability for ratings that turned out badly, or tried to legislate the criteria that rating firms use, that might just drive them to forgo the privileged status of being nationally recognized to avoid the weight of the associated shackles.

If rating firms did decide to try their luck simply as individual, if initially influential, voices in a cacophony of recommendations — more or less how the stock research industry works — it would greatly change the finance world.

For sure, ripping officially sanctioned ratings out of entrenched laws and regulations would be a wrenching process. But the potential upsides are many.

Investors would have to do their own work rather than rely on ratings. As a result they might not buy overly complex products at all. If they had operated on that basis a few years back, the indecipherable instruments that characterized the recent credit boom might well have received a much more skeptical reception.

More credit researchers would potentially compete, validating or challenging one another’s work. The problem of incomplete public disclosure, which regulators are to some extent trying to tackle, could fade because there would be less incentive for debt issuers to favor a small group of rating firms with privileged access to information.

Even the idea that rating firms should not be punished for errors, a tricky sell when they operate with government approval, would suddenly make more sense. And the debate over raters’ conflicts of interest would die down, because investors would be free to choose the credit research they found most useful, whatever the source and whoever initiated it.

There would be a further advantage in that lawmakers would not feel the need to dictate to rating firms how to go about their business. That’s already getting out of hand. The latest draft legislation is unlikely to survive intact, but CreditSights, an independent research firm, reckons aspects of it are “borderline surreal” and that over all it is too focused on allocating blame for the crisis rather than improving the system for the future.

Perhaps best of all, removing all official recognition and regulation of ratings would free up time and money for regulators around the world, allowing them to focus on more important things.

Of course, this whole situation is hypothetical. And moving toward it would involve a huge and costly transition, including the tricky job of ensuring that the big rating firms’ outsize influence didn’t somehow persist. Nonetheless, it’s one example of how less regulation might end up being better regulation. Sadly, that’s why interventionist policy makers are likely to stop short of letting it happen.

For more independent financial commentary and analysis, visit www.breakingviews.com.