What’s more, the lack of competition left the ratings agencies unable to detect their own inadequacies. A properly functioning market process might have revealed important information about the quality of ratings to the agencies, the same way market processes tell the makers of mobile phones that they should incorporate touch screens in their smart phones. The market is a discovery process.
The rules that created barriers to entry in the ratings business also create barriers to discovering important information. They shut down the discovery process of the market. It wasn’t just that the agencies weren’t incentivized to improve their ratings—they were blind-folded and prevented from understand their own errors. They had models and expertise to rely upon, but those can go only so far without a robust market process keeping everyone on their toes.
Even today, the ratings agencies do not seem to appreciate the effect that the barriers to entry had in crippling their business. In their testimony to the Commission today, many of the witnesses insisted that Moody’s sought to provide the best credit opinions possible with the information then available. There was no recognition that their oligopolistic status—which has provided them with decades of profits—was the reason they could not detect that they were doing such a poor job.
But the stymieing of market processes doesn’t explain why outside investors—especially our most sophisticated financial institutions—relied so heavily on the ratings agencies to gauge risk.
After all, the inefficiencies of monopolies have been well-known for quite some time. And the barriers to entry in the ratings business were readily apparent. Why did so many banks continue to rely on ratings agencies despite the obvious deficiencies? And why did this cause a crisis only recently, when the barrier to entry has been in place since the 1970s?
The answer seems to lie with a still obscure regulation adopted by the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision in 2001. The regulation—which is known as the Recourse Rule—set down the amount of capital banks have to set aside against different kinds of assets.
Unfortunately, it incorporated credit ratings to judge how much capital a bank should set aside.
This means that the government essentially mandated that banks outsource their evaluation of risk to the ratings agencies. One of the witnesses, former Moody’s employee turned whistler blower Eric Kolchinsky, pointed this out in his testimony.
“Not only did private investors outsource their risk management to ratings agencies, but the government did as well….For structured finance instruments, capital rules directly relied (and still rely) on the ratings agencies. The higher the rating, the less money a bank is required to set aside for any given instrument,” Kolchinsky told the Commission.
A few questions came up today about the role of regulations but the subject seemed largely lost on the panel.
It shouldn’t be lost. Setting aside money for capital reserves is costly for banks. Every dollar used to satisfy capital requirements is a dollar which the bank cannot lend out, which mean it doesn’t earn interest. It is “dead money.” The Recourse Rule allowed banks to keep more of their capital “alive” for lending and investing—so long as they followed the ratings agency’s views of risk.