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.