Wall Street. A cauldron of ego and ambition. 31 years ago, Gordon Gecko made famous the moral compass of finance: greed is good. Wall Street shows us through record profits and gilded bonuses just how well finance can work… until it doesn’t. But they identify their mistakes and learn from them, don’t they?
Ten years since the Global Financial Crisis (GFC) and we are seeing record highs in the S&P 500, FSTE 100 and Nikkei. One would almost think nothing has changed… and they would be right: it hasn’t. Growth is now exceeding pre-GFC levels but the checks and balances that failed to prevent the GFC are still in place. We didn’t fix the problem. We only survived it.
We often focus on banks, as the organisations that created risky financial instruments and funded this pernicious creativity by ensuring more mortgages were issued to people without the means to pay. We knew they would be tempted. They are for-profit businesses, and there was profit to be made. What the public needs to talk more about is the organisations that are supposed to guard against this temptation. I am talking about Credit Ratings Agencies (CRAs) and their failure to protect us. This article is about how we can guard against the guards.
The ratings CRAs provided are vital to costing securities issued by banks, because they determine what the risk is. The higher the risk, the lower the price and higher the yield may have to be to encourage buyers. It is then the nature of the financial system that these securities could then be sold from one financial institution to another and so on. It continues to be a multi-billion dollar game of pass-the-parcel. The CRAs failed us because they didn’t tell anyone the parcels were ticking.
They failed to sound the alarm because they didn’t do their due diligence, made bad assumptions, and the banks hired former CRA analysts to game the system. But what was worse is that CRAs get paid by the issuer of the security for the rating. Therefore the CRA has an incentive to give better ratings, thereby ensuring future work from the issuer. In fact, 90-95% of CRAs’ revenue comes from these ratings. What we need is better incentives for CRAs to provide accurate ratings.
Regulators in the United States and Europe, the two largest markets for CRAs, have not succeeded. Reforms have mostly focused on increasing oversight but this has not been sufficiently effective. There have also been attempts to secure accuracy by increasing the number of CRAs – a competition for accuracy. But this has been flawed in its delivery, and misguided in its aim. What we need is to harness the CRAs’ desire for profit and market share so we get accurate ratings. The answer has been staring us in the face. We should rate the ratings agencies based on accuracy.
But here is the problem: who should investigate the CRAs for accuracy? The same regulators who were asleep at the wheel for the GFC? No. What we need is an investigator who is an expert on the market and knows the latest tricks a CRA might pull. What we need is someone who would want to find errors and help said CRA lose their reputation for accuracy. What we need… is a competitor.
The Big-Three CRAs (S&P, Moody’s and Fitch) have 95% of the global market share and have been the leaders for years. They built this market share on a reputation for accuracy. But they have other competitors. There are seven other CRAs in the United States, and another 41 CRAs in Europe all eager for market share. With each of these CRAs eager to discredit the others and gain market share, and therefore profit, imagine this.
The US and European regulators ask all CRAs in their jurisdictions to hand over their internal ratings data for review; just as they can now to ensure regulatory compliance. The regulators then sterilize the data of identifying characteristics and hand it over to another CRA, who has also handed in their data for review. All CRAs are now reviewing each other and hand over their findings to the regulators. The regulators then use that data to rate the CRAs (e.g. AAA, BB, etc) and publish them to the market. Such a report could cause some CRAs to fall from grace, the more accurate CRAs rise to take increased market share, and us be the safer for it. We would be making a true competition for accuracy.
We can use their greed to get more accurate ratings and help ensure the GFC does not happen again. Their greed for market share could help us all.
Maybe this time Gordon Gecko is right.
Greed is good.
Nicholas Filer is a Brisbane based writer with honours degrees in law and international relations.