Their Just Deserts

You’d think that the ratings agencies, beneficiaries of enormous government subsidies, and, as I’ve pointed out before, the most culpable villains in the financial crisis, would be getting their comeuppance in regulatory reforms making their way through the Congress. Not a bit of it:

This morning we had hoped to be able to praise House Financial Services Chairman Barney Frank, who seemed ready to break up the credit ratings racket that did so much to inflame the financial panic. But just when you think Barney will free up competition, he reinforces the cartel.

The news came at yesterday’s hearings into why the government-anointed credit-ratings agencies—Moody’s, Standard and Poor’s and Fitch—slapped their seals of approval on billions of dollars in dodgy assets during the credit mania. A former Moody’s employee, Eric Kolchinsky, described a “reckless disregard for the truth” in an August memo to a Moody’s official. Yesterday he testified that those responsible for ensuring sound ratings methodology are “routinely bullied” by management. Another former Moody’s man, Scott McCreskey, testified about the company’s failure to monitor the growing risks of municipal bonds. Moody’s has generally denied the allegations but says it is investigating.

Yet despite the path of financial destruction paved by the Big Three raters, Washington still won’t yank their privileged status as Nationally Recognized Statistical Ratings Organizations (NRSROs). Based on the draft reform written by Mr. Frank’s colleague, Paul Kanjorski (D., Pa.), the raters can expect more compliance and legal costs, but no threat to their official role as America’s judges of credit risk.

The underlying problem is that our financial regulation process is broken due to something called “regulatory capture”, the tendency for regulators to view those they’re supposed to be regulating as allies (or prospective employers) rather than as adversaries. As long as regulatory agencies are seen as places for people who can’t get a job elsewhere or as a good place for newly-minted MBA’s to make contacts before taking a real job making real money, presumably with one of the companies they were supposedly regulating, that’s going to be a problem.

Here’s my proposal. First, we need to increase the penalties for infractions sharply. Millions may sound like a lot of money but when the rewards are measured in the hundreds of billions or trillions, it’s small potatoes. We can’t let skating the rules be acceptable risk.

Second, divide a sizeable portion of the fines and penalties for infractions among the regulators. Change the incentives so that enforcement is attractive.

Laws and regulations are only as good as the enforcement that’s behind them. Byzantine regulations that are unenforceable and which we won’t bother to enforce aren’t disincentives to wrong-doing, they’re incentives to attorneys.