resilience, not stability

Rating Agencies, Financial Regulation and Goodhart’s Law

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It was only a matter of time given the focus on the Goldman-SEC case before someone decided to apportion some of the blame onto the ratings agencies. And sure enough, the New York Times has a story out on how the ratings agencies were an integral part of the problem because they gave banks free access to their models and ratings methodology. But this is true of all banking regulations – banking regulators too make their rules, models and methodology freely available to banks who then proceed to arbitrage these rules, primarily to minimise the capital that they are required to hold. This is not surprising given that ratings agencies are essentially an outsourced function of the banking regulatory apparatus. And the problem of arbitrage is also well-known – I have referred to it as the Goodhart’s Law of financial regulation.

The NYT article implicitly suggests that increasing the opacity and ambiguity around the ratings methodology would have resulted in a better outcome. This is similar to how Google tries to discourage people from trying to arbitrage its search algorithm by keeping it opaque. Just keeping the algorithm private is not enough as search-engine optimisers soon figure out the key features of the algorithm by experimenting with what works and what does not, which means that Google needs to continuously modify the algorithm to stay one step ahead of the arbitrageurs.

Maintaining a continuously updated, opaque algorithm is not a suitable strategy for ratings agencies. Even if a banker does not know the exact ratings methodology, he can easily figure out the key features just by running a large number of sample portfolios through the ratings system and analysing the results. Moreover, ratings methodologies that are unpredictable by design can create unnecessary ratings volatility and friction in financial markets. And last but not least, ratings agencies have no incentive to engage in such an arms race with the banks given that they get paid by the bank only when a deal gets done.

The role of ratings agencies in exacerbating the financial crisis has been exaggerated. As David Merkel puts it, “Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.” The mad rush to buy AAA bonds in the boom wasn’t as much a function of the irrational faith in ratings agencies as it was a function of the rational desire to obtain extra yield whilst not falling foul of internal and external rules and regulations. Even internal control functions in firms often limit the scope of investments by specifying minimum required ratings and then assume that this requirement makes all further supervision of the manager redundant. Unsurprisingly, the manager prefers even an expensive AAA to a cheap BBB bond.

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Written by Ashwin Parameswaran

April 24th, 2010 at 1:31 pm

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