Reforming the Selection of Rating Agencies in Securitization Markets : A Modest Proposal

One of the roots of the 2008 financial crisis was a deterioration of rating agency standards, which contributed to the widespread defaults in the residential mortgage-backed securities (RMBS) sector. In this paper we suggest a change to the rating agency selection process that removes much of the incentive for rating agencies to lower their standards so as to expand their business.In its simplest form, our proposal is similar to the process that applies to judging panels at some Olympic events: The most lenient judge is dropped. In the context of rating agencies, the most lenient rater is dropped, or the rating fee is withheld. Our proposal would apply not only to RMBS, but also to commercial mortgage-backed securities (CMBS), collateralized loan obligations (CLOs), and other asset-backed securities (ABS), such as auto and credit card receivables.If rating agencies' incentives for competitively lowering their standards are diminished, the argument for increased direct regulation of the agencies by the Securities and Exchange Commission (SEC) is similarly diminished