When you open a new restaurant, you’re hoping for good reviews. But we don’t just let new restaurants hire their own reviewers — that’s a good way to get some really worthless reviews. Think about it: who’s paying that reviewer anyway?
Paying for ratings is a bad idea for restaurants, and it’s an even worse idea for Wall Street. Today, it’s standard practice for financial firms to pay ratings agencies to rate their products. In economics, this kind of thing is known as a “perverse incentive.” In homes across America, it’s called “a bad idea.”
In theory, ratings agencies are supposed to act as independent voices who give investors honest assessments about complicated financial matters. In practice, however, they have incentives to churn out AAA ratings, collect hefty fees, and promote inaccuracy that could help bring about another financial crisis. It was one of the major factors that contributed to the economic crisis of 2008 — ratings agencies were incentivized to give bad products good ratings.
Right now, when a big bank needs a rating, they can shop around between agencies. Thanks to a provision I got included in the Dodd-Frank Wall Street reform bill, the SEC has the ability to end that shopping process. It has the authority to encourage ratings agencies to be more honest and accountable by having an independent board direct financial instrument ratings to the agencies that are most accurate. But there’s a bunch of lobbyists fighting us, and I need your help.