One of the many things I learned reading the literature on standards is how they tend to set floors on behaviors. I was reminded of that from this posting from Kevin Drum
I want to highlight a single passage from the Roger Lowenstein article that I blogged about below. It’s about how investment bankers create complex financial instruments that receive high ratings:
Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails….The challenge to investment banks is to design securities that just meet the rating agencies’ tests….”Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says.
Go ahead and call me a rube, but is this for real?
This is a bit like being surprised that the lunch on your airplane flight bears no resemblance to what would pass muster as lunch at mom’s house. In fact I love that the airline industry at one point had to convene their industrial standards body only to set a standard for what counted as a sandwich; since some carriers handing out “sandwichs” while others were actually providing a sandwich. Of course once you set the standard everybody in the industry pretty quickly starts handing out the minimum meal that meets the standard.
This kind of gaming of standards is well standard. One way to temper the effect is to keep the rules fuzzy. It is oddly perverse that if you give the regulators wide latitude in their enforcement you can undermine this gaming; since the regulated players will then have to strive to overshoot the standard sufficiently to avoid the risk of failing to meet it. The players will then complain that the rules aren’t clear and that the regulators are capricious. Another trick is to make the standard a bit competitive so only top N% get the rating. The judging will give an element of fuzziness, and it also creates striving for improvement. But then tends to create demands for the judging to be more transparent – a proxy for the return of the bright line – in the name of fairness.