No analysis of last years economic meltdown is complete without a discussion of the role financial ratings agencies played in the crisis.
Policymakers have long been puzzled by ratings agency conflicts of interest. Time and again ratings agencies are accused of shirking that is, passing off low-quality ratings undetected until some sudden corporate or market failure reveals the shortcoming and absconding with their earnings from having done so. Economic literature, however, provides a long and varied history of theoretical microeconomic research that explains shirking and absconding among monopoly firms where there exists no legal or economic recourse for such behavior.
Through the lens of economics, it also becomes clear that shirking and absconding are not limited to credit rating agencies, but apply to corporate governance ratings agencies as well as others. Like credit ratings agencies, because of its influence with institutional investors, the corporate governance rating industry plays a major de facto regulatory policymaking role. The regulatory function operates on the basis of two major levers: shareholder votes and corporate governance ratings. In practice, the two are related, wherein the proxy firms recommend voting positions in shareholder elections justified by their own corporate governance ratings metrics.
Some observers, including former Rep. Richard Baker (R-La.), who was a senior member of the Financial Services Committee, have raised concerns over potential conflicts of interest within some governance firms, arguing that conflicts of interest and a lack of competition in the industry could lead firms to provide biased advice. A study undertaken by the Government Accountability Office at Bakers request reached similar conclusions. (Baker is now president of the Managed Funds Association.) Recent academic literature, too, has begun to show evidence that corporate governance ratings are of little value, which is consistent with the classic noncooperative games characterization of ratings agencies that shirk in the production of hard-to-value information products before absconding with the proceeds from selling their useless or worse yet, harmful ratings.
But even more than credit ratings, corporate governance ratings agency practices and conflicts of interest have important implications for U.S. business performance and along with it pension fund and individual investor performance. We should have learned from the recent credit crisis that when the raters begin constructing the things they rate, the constructs are only as good as the models that rate them. Hence, the depth of todays recession is in part a result of the need not just to report losses on financial instruments, but to restructure instruments to new models of credit performance.
Corporate governance structures are far more complex than even the most complicated financially engineered security and will take considerably longer to restructure toward stability if the corporate governance rating models are wrong. Hence, not only are pension fund and individual investors at risk of corporate governance raters getting it wrong, but so are employees of the firms that are directed by the corporate governance rating industry and the local and regional economies in which they operate.
As I show in my forthcoming working paper with Charles Calomiris, without the ability to vote with their feet, users of corporate governance ratings (whether pension funds, individual investors or government regulatory bodies) are inevitably left vulnerable to ratings agency shirking and the repeated crises that it causes.
Proposed policy solutions focusing on investor- or issuer-pays distinctions miss the point: Monopoly ratings agencies that are protected from the legal and economic costs of shirking will inexorably shirk every time the marginal value of their information declines. In other words, every time a boom occurs leading to the now-familiar lament about ratings quality, market bubbles, and investor harm. Moreover, with existing legal and statutory protections, the industry is booming.
As a result, it is crucial to construct a stringent set of incentives for ratings agencies that allow users to heap significant harm on ratings agencies that exhibit adverse behavior. The policy question then becomes whether policymakers want to risk shutting down good ratings agencies to avoid even a whiff of the bad or letting bad ratings agencies sometimes prosper to preserve the good. To construct the former system would avoid the types of crises recently witnessed, but it would result in episodes in which ratings agencies that were unable to maintain investor trust are shut down, regardless of whether they were shirking and absconding. If we instead desire to maintain our present ratings industry system based on the latter error having firms occasionally abscond rather than occasionally unjustifiably shut because of reduced investor confidence regulatory, legislative and judicial bodies must be crucially relied on to increase ratings agency accountability and accuracy by meting out extremely harsh punishments when shirking is discovered.
So far in the crisis, such punishment has not been forthcoming. It is therefore incumbent upon Congress, relevant regulatory agencies and attorneys general to take swift action on not only credit ratings agencies, but all ratings agencies conflicts of interest and rating practices to ensure that ratings users are delivered high-quality ratings products untainted by the conflicts of interest implicit in the industry structure.
Dr. Joseph R. Mason, a senior fellow at the Wharton School and Hermann Moyse Jr./Louisiana Bankers Association endowed professor of banking at Louisiana State University, is the co-author of an upcoming study on the current practices of corporate governance ratings agencies that negatively affect investors.