Regulation And Ratings

There’s a fascinating new working paper at the NBER that examines how the confluence of ratings and regulation conspired to help create the 2008-2009 global financial crisis (abstract):

Rating Agencies
Harold Cole, Thomas F. Cooley

For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.

Skipping over the math, what Cole & Cooley observe is that credit ratings and rating agencies continue to function pretty well, even under the potential conflict of interest arising from the “issuers pay” model, at least for “vanilla” credit securities.

Doing Business Malaysian Style

The World Bank and the International Finance Corporation released their 2012 Doing Business Index yesterday. Malaysia climbed five spots to 18th (excerpt; emphasis added):

Malaysia up five notches in World Bank ranking

PETALING JAYA: Malaysia has jumped five notches to 18th place in the World Bank's Doing Business 2012 Report, placing it ahead of the economies of developed countries like Germany, Japan, Switzerland and Belgium.

The report highlighted Malaysia's steps in introducing electronic filing in courts, setting up specialised civil and commercial courts in Kuala Lumpur and creating a one-stop centre for business start-ups by merging company, tax, social security and employment fund registrations.

There He Goes Again…

Tun Dr Mahathir on free markets, regulation and gold:

Dr M: Banking, finance need to be regulated

…Former prime minister Tun Dr Mahathir Mohamad said governments must continue to oversee the regulation of banks and financial institutions.

“Unless the Government oversees and limits the ability for the market to abuse (the banking systems) then, of course, we are going to have this kind of (global economic) crisis…

…“This idea of a free market has become almost like a religion. You cannot question it, even when it fails,” he said…

…“And the abuses became rampant because of the idea that governments must not interfere with the financial market. (That) the market it seems would regulate itself,” he explained.

He urged for the gold dinar to be institutionalised as the standard against which all currencies were measured for the sake of stability.

“It’s something tangible and something that has value anywhere in the world,” he said.

However, he said the gold dinar system, if implemented, should only be used for settlements of international trade…

…“The US dollar has got no value whatsoever. It’s got no backing, no reserve. But we accept it as if it has some value and because we accept it, it has value,” he said.

Links of the Day

Jhong-Wha Lee & Ju Hyun Pyun argue that globalisation (specifically growth in trade) reduces the probability of conflict:

"The results may derive from the fact that an open global trading system will prevent a state from initiating a war against any trading partner because other trading partners in global markets prefer to do business with a "peaceful" player. Hence, global trade openness of the dyad can reduce the incentive to provoke a bilateral conflict. We also think that open states can be more peaceful because they become more susceptible to political freedom and democracy. They apply international law better and employ good governance. Trade openness can also lead to an "expansion of bureaucratic structure," which concerns itself with economic interests in addition to security interests — and is thus less likely to support military action."

Does that mean "engagement" is better than "sanctions"? Shall we then engage more with Iran, Myanmar and North Korea?

Jon Danielsson says more regulation is not the answer for financial market reform:

"In a financial crisis, where financial institutions are required by regulations to hold minimum capital, just that fact is destabilising. If asset prices are falling, the financial institutions need to sell high-risk assets which depress the price and therefore by itself erode their capital. This is why risk-sensitive capital increases systemic risk and forces banks to withdraw lending...Indeed, the banks are now doing what they are supposed to do. They are being prudent. It is a bit disingenuous of regulators and politicians demanding that the banks increase lending when the banks are just following the regulations designed by the very same regulators and approved by the very same politicians."