Role of credit ratings agencies must be reduced, says ex-treasury chief Paulson

More work needs to be done to reduce the influence of the credit rating agencies if the financial system is to be made safer, the former US treasury secretary Hank Paulson told an investigation into the credit crisis.

Mr Paulson urged a sweeping overhaul of securities laws, which currently set rules on the bonds that certain types of investors may buy depending on the rating assigned by the rating agencies.

Although the laws are meant to protect investors, they have in fact led the financial system into a false sense of security, Mr Paulson told the Financial Crisis Inquiry Commission yesterday. "I think, no matter how the rating agencies are regulated – and we need more regulation and we need more disclosure around the rating agencies – I do not like the fact that we have several rating agencies that are enshrined in our securities laws and regulatory manuals. I think that's just a crutch, and a dangerous crutch. I don't want to have the rating agencies held up as the font of all truth."

Grave errors by the major agencies – Standard & Poor's and Moody's being the leading two – led investors around the globe to believe that many complex mortgage derivatives would prove as safe as US government bonds, when in fact they quickly became worthless.

Reliance on agency ratings of bonds encouraged more investors to put money in the credit markets, widening the so-called "shadow banking system" which provided credit for the economy that did not have to be channelled through more heavily regulated traditional banks.

Tim Geithner, the current Treasury Secretary, also testified to the FCIC yesterday. He said that financial reform legislation going through Congress will pull much of the shadow banking system under the control of regulators. "A company like AIG or Lehman Brothers will not be able to escape consolidated supervision by virtue of its corporate form, and will have to operate on a level playing field with large commercial banks and traditionally regulated financial institutions," he said.