The 2008 banking meltdown revealed the credit rating agencies, those supposedly independent custodians of the global capital markets, to be incompetent. At the heart of that crisis two years ago were billions of dollars of securities made up of subprime mortgages which these agencies – Moody's, Standard & Poor's, and Fitch – had judged to be entirely safe. They were, of course, anything but. And those banks and financial firms that had crammed their balance sheets with these securities suddenly found themselves to be insolvent.
It has since emerged that these agencies were not only incompetent, but also possibly corrupt. The US Senate Subcommittee on Investigations has discovered evidence that Moody's and Standard & Poor's tailored their verdicts on the quality of subprime securities to win business from the banks which were issuing them.
There are gratifying signs that the financial authorities are, at last, waking up to the fact that this is a discredited industry. Last week the European commissioner for financial services, Michel Barnier, mooted new regulation for the agencies. And now the Securities and Exchange Commission in the US is reported to be considering action against Moody's.
The central problem with the credit ratings agencies is not the quality of their verdicts, lamentable though that has proved to be, but their quasi-official role in the global financial system. For decades, regulators have used their ratings to evaluate the safety of financial firms' balance sheets. Central banks have used agency verdicts to decide what collateral to accept from private banks. Insurance funds have rules specifying that they can only hold securities above a certain rating. This means that when the agencies get things wrong, the consequences are greatly amplified. When they are too lax, they can help to blow up a credit bubble. When they are too strict, they can set off damaging panics as investors rush to safety.
Various suggestions for reform have been made, including greater disclosure of the agencies' evaluation models, a requirement for investors (as opposed to securities issuers) to pay their fees, and opening up the sector to greater competition. But a better solution would be simply to remove these firms from their privileged position in the regulatory financial architecture. For too many in the financial markets, the rulings of agencies have become a substitute for independent thought. Investors and regulators need to get rid of this rotten crutch and stand on their own two feet.