Transparency is solution for ending role and power of rating firms

Since the beginning of the financial crisis, your humble blogger has been a lone voice saying that bringing transparency to all the opaque corners of the financial system is the solution for ending the role and power of the rating firms.

Why?

Because it undermines and eliminates the rating firms informational advantage.  Without this informational advantage, rating firms are no different than any other third party expert that investors can hire to assess a security.

With transparency, all market participants, including the rating firms, have access to the same information.

Specifically, everyone has access to all the useful, relevant information in an appropriate, timely manner so that the market participants can assess this information and make a fully informed decision.

With everyone having the same information, it then becomes the market participant's choice of assessing this information themselves or hiring a third party expert to assess the information for them.

Please note that market participants regularly make this choice.  For example, individuals invest in mutual funds to "hire" the expertise of the fund companies.  Portfolio managers, including hedge fund managers, "hire" experts to help them assess investments.

Of course, there is one other issue that must be addressed to end the role and power of the rating firms.  That issue is the use of ratings in regulations.

The use of ratings in regulations is a prime example of substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

For example, regulators use ratings in the Basel bank capital standards.

Why?  Assessing credit risk is suppose to be a distinctive competence of the banks.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants, including banking competitors, could assess the risk of the banks and exert discipline to ensure the banks are well capitalized.

By bringing transparency to all the opaque corners of the financial system, the use of ratings in regulations can be ended.

From a Wall Street Journal article looking at option for dealing with the rating firms,

How to fix a credit-rating system that failed so badly during the financial crisis, yet remains central to the functioning of global capital markets. 

The ratings industry is plagued by two self-reinforcing problems: an oligopoly dominated by three players—S&P, Moody's Investors Service and Fitch Ratings, a unit of Fimalac SA —and a business model based on a conflict of interest because debt issuers hire and pay those firms to rate their securities. 

Two solutions, both practical and radical, come to mind: breaking up the Big Three, and making it easier for investors and companies to sue them. 

Actually, there is a third solution:  restore transparency to all the opaque corners of the financial system and eliminate the rating firms informational advantage.

Academics and practitioners have been discussing such ideas for years, but so far the regulatory response has fallen short.

Of course the regulatory response has fallen short.  If transparency is restored to all the opaque corners of the financial system, the market's dependence on the regulators would virtually disappear.

No longer would market participants be reliant on the combination of complex rules and regulatory oversight as a substitute for the combination of transparency and market discipline.

Many of the changes proposed in the Dodd-Frank law have either been delayed by overworked regulators or scuttled by industry lobbying. 

No surprise there.

"Faith in regulators' potential to overhaul the rating-agency industry appears just as inflated as the ratings for asset-backed securities," Jeffrey Manns, an associate professor of law at George Washington University, writes in a new paper.

Please re-read the highlighted text as it doesn't apply just to rating firms, but to the financial industry itself.

Because of their conflicted position, regulators block the use of transparency to end the role and power of the rating firms.  As ending the role and power of the rating firms, dramatically shrinks the role and power of the regulators in the financial system.