Eliminating the Rating Agencies

Yes, I’m the same guy that wrote the series that culminated with In Defense of the Rating Agencies – V (summary, and hopefully final).  But I’ve heard enough unintelligent kvetching about the rating agencies, post Dodd-Frank.  You would think that some of them would realize there is something more fundamental going on here, but no, they don’t get the fact that the regulators have outsourced the credit risk function to the rating agencies, and that is the main factor driving the problem.  Okay, so let me give you a simple way to manage credit risk without having rating agencies, even if it is draconian.

Let’s go back to first principles.  As a wise British actuary said, “Risk premiums must be taken as earned, and never capitalized,” even so should regulatory accounting aim itself.

In general, earning Treasury rates is a reliable benchmark for an insurance company.  Match assets and liabilities, and never assume that you can earn more than Treasury yields.

But what if we turned that into a regulation?  Take every fixed income instrument, and chop it in two.  Take the bond, and calculate the price as if it had a Treasury coupon.  Then take the difference between that price and the actual price, and put it up as required capital.

I can hear the screams already.  “Bring back the rating agencies!”  But my proposal would eliminate the rating agencies.  All yields above treasury yields are speculative, and should be reserved against loss.  If the whole industry were forced to do this, the main effect would be to raise the costs of financial services.  It would be a level playing field.  Insurance premiums would rise, and banks would charge for checking accounts.

Such a proposal, if adopted, would simplify life for regulators, reduce risk for most financial companies, and lead to higher costs for consumers.  That’s why it will not be adopted, easy as it would be to use.

4 Comments

  • rational says:

    And would this be marked to market daily and capital adjusted accordingly? Best then to invest in the most illiquid instruments available so that no one can question your marks…

    • Marks don’t enter into it. Spread over treasuries at purchase/issuance does. So, if one issued a commercial mortgage (totally illiquid) the present value of the spread over Treasuries would be capitalized as a risk margin, and set up as capital.

      Regulatory accounting is a quarterly thing. Far from buying stuff that can’t easily be measured, this would incent financials to play it safe, because disproportionate amounts of capital would have to be set aside against the really risky stuff.

      • rational says:

        So the market perception of relative risk at issuance is perfect and capital need not be adjusted over time?

        • Hardly. I view markets as imperfect beasts that are unstable by nature, and resist stabilization.

          But the degree of capital put up in the bad years would still be high yet draining in the good years, and in the good years, not as much capital would be put up, which is a weakness of this proposal.

          But the amount of capital that this would require on average is far higher than any capital proposal I have seen. And that is one reason why those regulated like the rating agencies — they get to put up less capital than they would under more mechanistic schemes like mine.

          We would have far fewer insolvencies under a system like this — the downside is that credit would almost disappear… which given the past troubles would be a plus.

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