Guest post by Prof. Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business

The major credit rating agencies (CRAs)—Moody’s, Standard & Poor’s (S&P), and Fitch—contributed significantly to the financial crisis of 2007-09. Their excessively high initial ratings of residential mortgage-backed securities (RMBS) helped fuel the bubble of mortgage finance that ultimately burst, with near catastrophic consequences for the U.S. financial sector.

These disastrous failings motivated the post-crisis urge to tighten regulation of the CRAs. It’s not hard to share the (metaphorical) desire—reflected in the Dodd-Frank Act of 2010—to grab them by the lapels and shout “Do a better job!” 

There is, however, a better way, albeit one that is less intuitive and possibly less gratifying: namely, eliminate—or at least greatly reduce—the regulation of the CRAs. This would encourage entry into the credit rating business, stimulate innovation and, eventually, improve the efficiency of capital markets....