Cleaning up the ratings agencies

(breakingviews.com) -- Over-regulating credit ratings might just have a happy ending.

With rating firms under pressure from policymakers everywhere for their failures over complex structured finance ratings, there must be a tipping point at which they would give up their officially sanctioned status to escape the burdens any changes could bring. If that led to government-free ratings and ratings-free laws, the financial world could be a better place.

The U.S. Securities and Exchange Commission already approves Nationally Recognized Statistical Ratings Organizations (NRSROs) and is contemplating tightening oversight and regulation further -- maybe even making the likes of Moody's, Standard & Poor's and Fitch Ratings financially liable for rating errors.

Congress is in the game too, with new draft credit-rating legislation circulated last week and two hearings set for Wednesday. Even the National Association of Insurance Commissioners is taking an interest, because insurance watchdogs also use the rating firms' credit assessments.

The NRSRO badge goes alongside references to ratings in laws and regulations. Some of the specifics are unique to the U.S., but the overall picture is similar elsewhere. The U.S. Treasury and others have said that officials should work to reduce government and investor reliance on credit ratings. But the moves towards tighter regulation suggest authorities aren't ready to cleanse the system of ratings just yet.

But it's just possible to imagine that big rating firms might do it themselves if they are allowed to -- despite the fact that the SEC's seal of approval has helped the big rating firms entrench their market positions, and profitability, over the years.

For example, if Congress were to insist that raters shoulder significant liability for ratings that turned out badly, or tried to legislate the criteria that rating firms use -- both ideas in the latest draft legislation -- that might just drive them to forgo privileged NRSRO status in order to avoid the weight of the associated shackles.

If rating firms did decide to try their luck simply as individual, if initially influential, voices in a cacophony of recommendations -- more or less how the stock research industry works -- it would change the finance world dramatically.

For sure, ripping officially sanctioned ratings out of entrenched laws and regulations -- not to mention out of lending agreements and credit investors' thinking -- would be a wrenching process. But the potential upsides are many.

Investors would have to do their own work rather than relying on ratings. As a result they might not buy overly complex products at all. If they had operated on that basis a few years back, the indecipherable -- and, as it turns out, dangerous -- instruments that characterized the recent credit boom might well have received a much more skeptical reception.

More credit researchers would potentially compete, validating or challenging each others' work. The problem of incomplete public disclosure, which regulators are to some extent trying to tackle, could fade because there would be less incentive for debt issuers to favor a small group of rating firms with privileged access to information.

Even the idea that rating firms shouldn't be punished for errors -- a tricky sell when they operate with government approval -- would suddenly make more sense. And the debate over raters' conflicts of interest would die down, because investors would be free to choose the credit research they found most useful, whatever the source and whoever initiated it.

There would be a further advantage in that lawmakers would not feel the need to dictate to rating firms how to go about their business. That's already getting out of hand. The latest draft legislation is unlikely to survive intact, but CreditSights, an independent research firm, reckons aspects of it are "borderline surreal" and that overall it is too focused on allocating blame for the crisis rather than improving the system for the future.

Perhaps best of all, removing all official recognition and regulation of ratings would free up time and money for regulators around the world, allowing them to focus on more important things.

Of course, the whole scenario is hypothetical -- and moving towards it would involve a massive and costly transition, including the tricky job of ensuring that the big rating firms' outsized influence didn't somehow persist. Nonetheless, it's one example of how less regulation might end up being better regulation. Sadly, that's why interventionist policymakers are likely to stop short of letting it happen.