DOUGLAS: Regulate the raters, but not too much

January 16, 2010

In Washington, the Senate Banking Committee is considering far-reaching legislation regulating the financial services industry in the wake of the recent and ongoing crisis. This legislation will dramatically change the relationship between the federal government and some of our financial institutions.

Among the most important players in the financial industry, but perhaps not well-known to the public, are the credit rating agencies (CRAs). Like many of the other players, the CRAs did not anticipate the severity of the financial crisis of 2008. Consequently, federal policymakers, and the CRAs themselves, agree that regulatory reform is needed to help avoid a repeat of the disappointing performance of ratings issued in the run-up to the crisis.

While a congressional debate over credit ratings may not dominate the headlines, Indiana’s taxpayers should understand the effect that ratings from these agencies can have on our local economy, especially with respect to infrastructure improvement and taxation.

Often, when local governments raise money for infrastructure projects, instead of taking a loan from a bank, they borrow money directly from the capital markets by issuing bonds or notes. These bonds are typically sold to private investors, who provide the cash to make the building of schools, roads and community facilities possible.

Our ability as a city to secure a nationally recognized rating for our bonds helps expand our access to capital, which makes it easier to finance our projects. This ability directly affects our quality of life and our pocketbook.

So, given the importance of CRAs, a final bill from Congress needs to strike a balance between addressing the status quo, which even the rating agencies agree is unsustainable, and impeding the ability of these private-sector agencies to do their work.

First, there must be meaningful competition among the CRAs. Robust competition provides investors with a range of opinions on the creditworthiness of an issuer; any new regulation should consider the barriers it might erect to encouraging a competitive ratings market.

Second, new regulations must acknowledge that capital markets are now global. Policymakers should coordinate their efforts internationally so that inconsistent approaches do not engender confusion in the global markets.

Third, while there are proposals worth considering that might help address conflicts of interest, Congress should focus immediately on increased transparency and public disclosure, so investors know what they are getting from the CRAs now. Additionally, publicly disclosed measures of historical CRA ratings performance would encourage a healthy free-market discipline.

Fourth, monitor the CRAs, but let them do their job. We need strong government oversight, but the raters, not the government, should still be the ones making analytical decisions.

Finally, under existing laws, CRAs and other market participants may be held legally liable if they intentionally or recklessly issue material and false statements. While we need to ensure greater accountability from the credit ratings agencies, our reforms should not be such that every default of a business or municipality generates a cascade of lawsuits against the ratings agencies. Investors should not mistake ratings for guarantees.•


Douglas is managing partner of C.H. Douglas & Gray LLC, an Indianapolis financial advisory and investment firm.

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