All That Glitters / A Soporific Regulation Alert

Thieving brokers? Lying bankers? Swollen salaries? Distorted data? Corrupt officials? Legislate!

The latest craze in the financial world is regulation. With the greed exposed and the many and myriad evils that drove the financial system bared, there's a mad rush to the obvious solution.

Thieving brokers? Lying bankers? Swollen salaries? Distorted data? Corrupt officials? Legislate! Rush through laws that require more disclosure, clearer transparency, more restrictions! Whatever it takes to avert another crisis like this, enact it! One of the great achievements of the G20 meeting last week, say the experts, is international agreement about new supervisory mechanisms over the financial industry.

Our leaders are right, of course - the crisis did prove that the American system of self-regulation by the financial institutions didn't work. The idea had been that banks and investment firms would behave responsibly out of loyalty to their shareholders. But in reality, the managers at these companies proved loyal mainly to themselves, and to the company owners.

The result was massive collapses and a tremendous loss of shareholder value. Even the father of the system, former U.S. Federal Reserve chieftain Alan Greenspan, admits was wrong.

But not every new regulation, however appropriate it may seem at first glance, delivers the desired goods. The devil is in the details. Regulation can solve some problems, but it can also keep things as they are, or worse - it can harm.

Take a fresh example from our home turf. Last week the Israel Securities Authority suggested regulating the credit rating agencies, which had, in hindsight, overrated many companies. Investors had widely relied on evaluations by the credit rating agencies, which amplified their responsibility for the meltdown, the ISA justly concluded.

Its bill proposes that the agencies meet a long list of criteria, including organizational and operational requirements that would increase transparency and avert conflicts of interest. The ISA's demand are designed to strengthen the accountability of the controlling shareholders and management, ensure that the agencies employ properly accredited staff. and improve monitoring over the methods and activities of the agencies.

Sounds great, doesn't it? Documentation and transparency almost always improve the market, but they do nothing about the rating agencies' underlying conflicts of interest: Their revenues come from the very companies they rate. They have no other business model. If they are banned from charging companies for evaluating them, they'll collapse on the spot.

How will the credit rating industry look if the ISA's idea becomes law? The present situation would be perpetuated. Israel would have just two rating agencies, Maalot and Midroog, which will continue to be paid by the companies they critique.

The regulatory requirements will preclude the genesis of competitors with a business model that isn't tainted with a fundamental conflict of interest.

There's another, worse upshot, which is that the two agencies would be elevated to a semi-official status because they'd be regulated and supervised by the ISA. Investors would figure they've received the stamp of approval.

But rating companies isn't like construction. It involves subjective evaluation by teams of economists based on partial, filtered information provided by the company, about the company's own ability to meet its liabilities.

Even without the inherent conflict of interest, it's not a science. The problem is that when an officially approved rating agency issues a rating for a company, investors won't feel they need to think for themselves and do their own homework.

Even before the crisis, the investment committees at the big institutions accepted these ratings as gospel. Companies with an AA rating could raise hundreds of millions of shekels with a snap of the fingers. Once the ISA has kosherized the credit rating agencies, the situation can only get worse.

I can imagine the interaction between a frustrated investor who lost his pants on bonds, and his investment adviser: "What do you want from me? The paper had an AAA rating from an agency that employs the best economists and is supervised by government, too," the adviser will protest as the tears trickle down the investor's cheeks.

Of course, this isn't a problem unique to Israel. Many economists claim that the official status of the credit rating agencies was a convenient fig leaf that bankers used to milk the investing public.

Regulation is needed. But done hastily, it can do more harm than good. In the case of the credit rating agencies, what we need is a market consisting of agencies whose revenues don't derive solely from the companies they inspect. We also need institutional investors that do their own homework and analysis, whether a bond has an "official" rating or not.