One thing we learned in the aftermath of the financial crisis is that ratings agencies like Standard & Poor's or Moody's did not do a very good job assessing the quality of financial products. They graded mortgage securities packed with predatory subprime loans AAA (as good as cash, essentially) prior to their 2008 transformation into "toxic assets." This caused all kinds of problems, but one specific problem is that federal regulators relied on the ratings agencies when assessing bank capital. If banks had AAA securities, regulators were confident that they could withstand a crisis, creating a dangerous complacency as those highly rated securities evaporated.
In the new financial-reform law, Congress has instructed regulators to stop relying on the ratings agencies -- see some earlier commentary on this idea -- and instead evaluate the quality of bank capital themselves. "Among the options being discussed is a greater use of credit spreads, having supervisors develop their own risk metrics and a reliance on existing internal models," reports The Wall Street Journal. While this move isn't guaranteed to solve the problems of regulatory ignorance and ratings-agency failure, by forcing regulators to develop their own standards, we'll have a useful parallel assessment of capital quality that doesn't rely on the incentive of profit, at least directly.
-- Tim Fernholz
