Problems at the ratings agencies contributed to the crisis, and it's important for financial reform legislation to address the problems in this industry. The issues arise from the fact that the ratings agencies are paid by the firms whose assets are being rated. This gives the ratings agencies an incentive to issue pleasing ratings to encourage future business, and with enough money on the line, this can lead to large distortions in the risk assessments.
There are many ways to break the link between the ratings that are given and prospects for future business, e.g. the randomized selection of the agency that rates the assets that Dean Baker has been proposing, and the current proposal from the Senate takes a step in this direction. Lucian Bebchuk describes the Senate legislation, and explains how tying the profits that ratings firms earn to their actual performance breaks the link between issuing tough but accurate ratings and losing future business:
Rating the Raters, by Lucian Bebchuk, Commentary, Project Syndicate: In the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. ...
What should be done? One proposed approach would reduce the significance of the raters’ opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognized agencies.
Disappointment about the raters’ performance, and skepticism about the effectiveness of regulation, has led to calls to eliminate any regulatory reliance on ratings. If ratings are not backed by the force of law, so the argument goes, regulators ... can leave the monitoring of raters to the market.
Even if ratings were no longer required or encouraged by law, however, demand for ratings – and the need to improve their reliability – would remain. Many investors are unable to examine the extent to which a bond fund’s high yield is due to risk-taking, and would thus benefit from a rating of the fund’s holdings. Given past experience, we cannot rely on market reputation to ensure that such ratings will be reliable.
Another approach would be to unleash the liability system. ... But ... judicial scrutiny ... cannot ensure that raters do the right thing... There is thus no substitute for providing raters with incentives to provide as accurate a rating as they can. This can be done by making raters’ profits depend not on satisfying the issuers that select them, but on performing well for investors. ...
The US Senate voted this month to incorporate such a mechanism into the financial reform bill that will now have to be reconciled by the bill passed by the US House of Representatives. Under the Senate’s approach, regulators would create rules under which an independent regulatory board would choose raters. The board would be allowed to base its choices on raters’ past performance.
For such a mechanism to work well, it must link the number of assignments won by raters, and thus their compensation, to appropriate measures of their performance. Such measures should focus on what makes ratings valuable for the investors who use them...
Predictably, the Senate’s bill encountered stiff resistance from the dominant rating agencies. ... Rating agencies have been and should remain an important aspect of modern capital markets. But to make ratings work, the raters need to be rated.
At this point I'm not picky about how the incentive to issue higher than justified ratings is removed, there's more than one way to do this, the main thing is that a strong and effective mechanism along these lines is included in the final bill. [There also needs to be an entry and exit mechanism so that firm's that consistently give misleading risk assessments are driven from the set of authorized ratings agencies and replaced by new entrants to the industry.]