The most interesting part of Murphy’s article is how government regulations regarding credit ratings agencies prevented a vital feedback mechanism for evaluating their efficacy.
‘The Role of Regulation
Finally, consider the role of government financial regulation. There are various rules specifying minimum levels of safety for assets satisfying capital requirements of depository institutions. Yet, the government rules can’t specify merely the rating; they must also specify the acceptable issuers of such ratings. A commercial bank can’t hold a portfolio consisting entirely of bonds issued by cryogenic freezing firms; that would be far too risky in the present environment, in which the government supposedly keeps depositors and investors “safe.” But what if the president of the commercial bank hired his cousin Fred to type up, on official letterhead, “These cryo bonds are all AAA rated”? Would that make a difference?
The answer, of course, is no. The government and Fed’s financial regulations force firms to give their business to the industry leaders in the credit rating business. In other words, it’s not enough for the federal government to say, “A bank must satisfy certain capital requirements relating its equity to risk-weighted assets.” No, the government must go further and specify which agencies are allowed to provide the ratings that are used when calculating “risk-weighted assets.” This crucial fact is a large part of why, even after the Big Three performed miserably during the housing bubble years, they are still in business.
In contrast, in a free society, there would be no coercive regulations imposed top-down on the financial sector. If a bank wanted to attract depositors, it would need to convince them that its assets were sound. There would still be a role for ratings agencies, so that investors could buy bonds more knowledgeably, but if there were a huge screw-up — where a particular ratings agency gave horrible guidance on an entire class of assets — then that company would be heavily punished. The rest of the market could quickly adapt and no longer treat that agency’s pronouncements as authoritative, because there would be no regulatory code declaring them so.‘