For those of you who have followed the financial crisis one point of focus has been the failure of the credit rating agencies; the common story sob story being, ‘I invested in triple AAA bonds and now I’ve lost everything; how could this happen. Those credit rating agencies failed to do their job.’ I’d like to make the argument that the legal framework that gave rise to the rating agencies as a business is the problem and not the rules and regulations that the agencies where under or business practices that the agencies have used.
Not to suggests that the structure and practices of rating agencies, such as being paid by the issuers, helped, but these only accentuated a much more significant problem that is being caused by their existence.
People will argue that the agencies exist so that they can achieve economies of scale on investment research, which although is impart true, is not what I think the real reason is for their existence: they have been deemed the prudent man and thus many other ‘managers’ are using them to pass the buck with regards to their fiduciary responsibility. You may have heard, ‘It’s not my fault; it was rated AAA’, coming from an office near you.
The Prudent Man Rule states that fiduciaries should ‘observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested’; this not so insightful statement puts managers in a corner where they need to find another guy whose doing something like they would like to do so they can justify themselves, or they can have no opinion at all and just pass on their fiduciary responsibilities to the prudent man.
This leads to capital markets where money, instead of trying to determine where the best risk adjusted returns are, is looking to the next guy (the agencies) to see where it should go. So how is the agencies being very wrong the product of this setup; its not, but the real problem is that the whole capital market ended up bring wrong not that one investor was wrong. We need robust capital markets where savers place their capital in the hands of managers who invest based on their perception of economic principles and relationships (and thus disagreement occurs) rather than a legal framework.
Let me suggest a replacement to the prudent man rule – call it the robust pools of capital rule – managers must provide information to their clients detailing their investment process and strategies at a level that could be understood and cover the fact that outcomes are uncertain and that all strategies have the some possibility of total loss (just varying in size) and that THEY WILL NOT OFFLOAD THEIR RESPONSIBILITY TO RESEARCH THE INVESTMENTS THAT THEY UNDERTAKE IN ENTIRETY TO A THREE LETTER SYMBOL.
When everyone started following the prudent man (note: singular) rule the capital markets stopped allocating and the prudent man rule became imprudent.
January 18, 2009 at 11:53 pm |
[...] Regulation: How to write rules A G30 committee recently released a report highlighting the need for financial regulation reform. I tend to agree with a number of the points although in line with expectations for a high level report its recommendation lack a degree of concreteness that one might wish for. They want to make decisions about who is on the inside of financial regulation explicitly rather than a product of status quo. This comes along with the recommendation that the regulatory should be centralized. They suggest that their should be a robust framework for financial firms failure and the some systemically significant a firm is the tighter the regulatory should be. They even had a reasonable framework for how to define systemically significant: F(ss) = (Size, Leverage, Interconnectednessss, Significance of services). Other recommendations included greater transparency (ala a 10-k for structured financial products). This quick overview I tend to agree with. Two recommendation which although I don’t disagree I think missed the target a little bit are (1) update FVA (fair value accounting) account to prevent illiquid assets from causing a problem and (2) realign the incentives of the CRA (credit rating agencies). FVA is a language and it provides information, hiding information about the value of the business strikes me as incorrect. Having capital and funding bases which are match (so they can’t run) seems to be correct. Although being able to write down you liabilities is foolish (you still have to pay back on par); that rule should be changed. CRA’s quasi regulatory role should be eliminated and policy should discourage the correlation of analysis not encourage it. [...]