I’m teaching a seminar on the Financial Crisis this semester, and so I was intrigued when I saw this article about a new paper that proposes a simple reform to improve credit ratings.

As most readers probably know, one of the problems that led to the crisis was a gradual deterioration in the quality of the credit ratings issued by agencies like Moody’s and Standard & Poor’s.  The basic charge has been that the agencies, paid by the issuers, had an incentive to issue inflated ratings.  If they did not, the issuer would simply turn to another agency.  The competition for business among agencies was destructive and corrupted the integrity of the rating.

There have been lots of proposals to reform the process – everything from greater disclosure to disgorgement of profits – but Howard Esaki and Lawrence J. White have a simpler idea.  They would simply create a rule that if the issuer goes to more than one ratings agency, the issuer is required to drop (or not pay for) the most lenient rating.  

They have a couple of variations, but the basic idea is the same – ratings agencies won’t compete to give the most lenient rating if the most lenient rating is never used or paid for.  They focus specifically on securitizations, and the amount of subordination each agency requires for the top ratings, because (in their view) this is the aspect of the process that needs the most intervention.

I gotta admit, it sounds like this would be a pretty elegant and effective solution.