Correction Mechanisms Shall Set Us Free

Abstract

Market protection mechanisms work well during calm periods, but some fail miserably during slowdowns, at just the time we need them to work. When the market environment turns inhospitable, the accelerators take over from the brakes. This article frames the issues concerning oversight mechanisms, which enabled the crisis, and structural mechanisms, which in many ways advanced it. We detail the potential for competition for clients to interfere with the objective judgment of three financial markets gatekeepers: the credit rating agencies, auditors, and asset pricing firms. Any perceived bias in the quality of gatekeeping services can undermine market confidence. We then explore regulatory and contractual shortcomings that, in the event of a downturn or crisis in confidence, can exacerbate a narrow complication. In addition to the classic lemons problems in the context of information asymmetries, the tight relationship between ratings and prices perpetuate any re-rating or repricing scenarios—they combine to create an overwhelming downward force. Serious action is required. If unattended, these shortcomings leave our economy needlessly exposed to the same crisis-era systemic risk concerns that present themselves when downturns can spiral, unrestrained, into meltdowns.

TOPICS: Legal/regulatory/public policy, tail risks