Markets are the best regulators

Since the start of the current financial crises, we’re told that markets are at fault. The most common diagnosis is that there’s not enough regulation in place, and only a move away from reliance on markets and toward more laws and regulations will save the economy.

One thing that did happen is that someone misjudged the risk that was present in the mortgage-backed securities that led to the downfall of several investment banks. A recent article in the Wall Street Journal does the best job I’ve seen of explaining how this mistake, made by credit rating agencies, was responsible for this crisis. The article, written by Robert Rosenckanz, is Let’s Write the Rating Agencies Out of Our Law. Here’s a summary, as best as I can produce, of this article:

Rating agencies can make mistakes.

Regulatory agencies used these ratings in formulating their regulations. “Most importantly, bond ratings determine — as a matter of law — how much capital regulated institutions need in order to own the bonds.”

“Since the ratings determine required capital, they have a profound influence on how financial institutions invest their assets — in effect, the regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system. And every actor in the financial system has every incentive to group and slice assets in ways that maximize not their fundamental soundness but their rating.”

“The problem was not the erroneous ratings per se; everyone misgauges risk and ratings agencies are no different. The problem is that these erroneous ratings were incorporated into law. Regulators should not have relied on ratings agencies to asses the risk of bond holdings. Instead, they should have relied on markets.”

Markets are superior to small groups of people — the credit rating agencies in this case — in making decisions. Because of regulation, however, the financial system was forced to accept and rely on these ratings. That, in turn, led to disaster.

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