You may recall that much of the shoddy financial work on Wall Street during the last crisis came with a stamp of approval from one of a handful of rating agencies (Moody's, Standard and Poors, etc.) that determines the quality of a bond. They did not do a good job: Ninety-three percent of AAA-rated sub-prime mortgage bonds since 2006 have been downgraded to "junk" status.
Imagine buying a car that was rated in the top of its class and discovering that its only use is being sold for scrap. You would think an institution that had screwed up so spectacularly would be losing business, but as far as I can tell, none of the ratings agencies have suffered for their failures. Tell it to the efficient markets experts.
The financial-reform bill in the Senate does not do a ton to solve this problem. That's in part because it's a difficult problem to solve. Ratings agencies are paid by the people selling debt -- an obvious conflict of interest -- but no one else wants to pay for them. Someone buying debt has a better incentive to pay for a rating but that creates a free-rider problem where one buyer funds ratings for an entire universe of potential purchasers. The whole thing is a strange phenomenon of the market.
In the meantime, what we'll get is tinkering around the edges: A new office in the SEC, new examination authorities, disclosures of methodology from the raters, some internal firewalls between sales staff and raters. But you still have sellers paying for ratings. Paul Krugman thinks this proposal to have the SEC essentially run the process and act as a middle-man between sellers and raters might be a better idea.
The other possible solution, mentioned in that proposal and hinted at in the legislation, is to introduce actual competition among the ratings agencies. The current legislation would stop regulators from relying on these agencies when they make decisions in order to take away their legal weight and create better incentives; currently, ratings agencies seem as responsible for the quality of these securities as the companies issuing them. However, as another proposal suggests, further steps to lower the regulatory barriers of entry to potential competitors of the existing agencies might be an even better answer.
This may be a weird case where smart deregulation could bring greater safety to the market.
-- Tim Fernholz