WE RECEIVED some interesting comments on yesterday's post about ratings agencies. I wondered why they have not been held accountable for  their role in the financial crisis. The markets depend on AAA meaning AAA, and the agencies slapped their top rating on securities that turned out to be otherwise. Commenter bastiat1 offers an inside prospective:

Amen. I'm a former compliance officer at one of the Big 2 rating agencies, and had a front-row seat as the house of cards fell—all the while listening to more and more elaborate strains of denial from top management.

I would have to disagree with the notion that the analysts and their managers were incompetent, however. They were in fact quite competent at doing what was best for themselves. They knew the ratings were on thin ice, but handed out ratings which kept the revenues (at 50% margin), and their bonuses, rolling in.

Perhaps the best indication of the contempt with which rating agencies view regulation and compliance is provided by the background of Moody's new head of compliance—prior to his elevation to that position, he was the manager responsible for the team which rated subprime mortgages...

The incompetence, in my view, lies with Congress and the regulators for failing to write regulations with any teeth. The rating agencies successfully lobbied against the inclusion in the CRA Reform Act of rules regarding the actual methodologies used to rate securities, and limited themselves (and thus also Compliance departments) to vague requirements requiring the agencies to disclose and 'manage' conflicts of interest and to protect confidential information.

Rating agencies face many of the same challenges as regulators. Their employees get relatively low pay, but must have skills that would command a higher salary elsewhere. Some people work at the agencies in order to gain the credibility and insider knowledge to make it elsewhere, usually a bank. But this creates a conflict of interest between the banks and the agencies.

Further, the agencies are an oligopoly, with dominant firms competing for business. Banks want to work with an agency that will give their securities a credible and high rating. That, as commenter djames-san francisco points out, creates another inherent conflict. The rating agencies end up competing with each other to offer more favourable ratings.

No new regulatory structure will be complete without overhauling and regulating the credit rating business.