Sunday, August 7, 2011

What should we do about Credit Rating Agencies?

The Case for a Parallel Ratings Agency

We all know that the 2008 financial crisis began with the collapse of market for Mortgage-Backed Securities (MBS) Collateralized Debt Obligations (CDO and CDO-squared). What many people never gave much thought to is the fact that more than 90% of these financial products enjoyed a AAA rating despite being based on sub-prime real-estate lending.

Why was this? In short, its because the ratings agencies (Fitch, Moody's and Standard & Poor) all get paid by the issuer of the security. This is a conflict of interest if ever there was one. In economist-speak, we would call this "A Market for Lemons" or "Adverse Selection". Ultimately, the MBS and CDO markets turned out to be as reliable as the second-hand car market.


This paper offers an explanation for the 2008-2009 financial crisis using an adverse selection model for the asset-backed security and collateralized debt obligation markets, in which more than 90% of assets enjoyed a AAA rating despite  being based on sub-prime real-estate lending.  Because the classical adverse selection incentive-alignment response would be ineffective during episodes of bankruptcy in the financial markets,  alternate arrangements for incentive-alignment are necessary.  A public-sector rating agency would align the incentives of private-sector credit-rating agencies via a reputation effect. This public agency would in-turn maintain its integrity and neutrality via central-bank-style policy independence architecture.
About the Author:

Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.


  1. Nothing! Let the credit ratings agencies be! Just ignore them for any regulatory purpose. It suffices that the market clears for any risk information they contain.

    It was when regulators also used them to set their capital requirements for banks that the banks overdosed on risk perceptions and ended up with obese exposures to what was and is officially considered as not-risky, like triple-A rated and infallible sovereigns, and anorexic exposures to what was and is considered as risky, like small businesses and entrepreneurs.

    Occupy the Basel Committee!

  2. I'm afraid I don't agree. (even though, I quite liked your video lecture).

    Fundamentally, the market for risk information is broken. I think its quite clearly the case, given that it is characterized by oligopoly, information asymmetry, and conflicts of interest in the payment/incentive scheme.

    Now,as far as dropping regulatory reliance on the rating agencies is concerned, you certainly have a point that regulatory insistence on rated assets was a problem. In the US, that has been addressed by the Dodd-Frank Act.

    In my view, dropping regulatory requirements for asset ratings, as in Dodd-Frank is necessary but not sufficient. The reason is due to the role of institutional investors (who are especially big in Europe). They will always have fiduciary standards. While some countries reinforce their fiduciary standards by law and regulation, fiduciary standards are also reinforced everywhere they exist by litigation. So, even if regulations change, the fiduciary standards will stick.

    What the financial markets need is reliable, high quality information, which is widely available. After all, that is supposedly one of the three preconditions for a functioning market.

    I must say though that I really like the idea in your video about heterogeneous capital requirements. I myself am a huge proponent of credit policy.

  3. This is really cutting edge machines. It is really good for business too.