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NEW YORK (Reuters Breakingviews) - It's a love-hate relationship. The White House doesn't like the fact that Standard & Poor's downgraded America's debt on Friday -- it even picked holes in the firm's numbers. European officials don't welcome critiques of sovereign credit, either. Yet governments seem broadly inclined to regulate rating firms tightly. The better answer is to cut them loose.
Without official recognition, the powerful big three raters -- S&P, Moody's Investors Service and Fitch Ratings -- would eventually become just competitors with other credit researchers. Investors would have to decide whose analysis was most credible. They could ignore S&P if they chose, or discount all three firms' views because of their many failures to spot early warning signs ahead of the 2008 crisis and look elsewhere for insight.
Last year's Dodd-Frank Act started a process of de-deifying the troika, requiring the U.S. Securities and Exchange Commission to find alternatives to the use of credit ratings in regulations. The SEC did just that in one area on July 26, specifying alternative criteria that qualify a debt issuer to use "short form" disclosure for new offerings.
At the same time, Dodd-Frank also requires the SEC to intensify its oversight of officially recognized rating firms. European Commission President Jose Manuel Barroso last month also talked about tighter regulation. He even hinted at encouraging homegrown rivals to counter a perceived anti-European bias (apparently forgetting that Fitch is majority-owned by France's Fimalac).
More pervasively, global Basel III rules on bank capital still have ratings baked in. It's not easy to find a straightforward alternative, but it shouldn't be beyond the imagination of bankers and watchdogs. Traditional ratings anyway carry far too much weight given their narrow primary purpose as indicators of default probability. A multifaceted approach would bring better risk management. The trouble is, even investors with the resources and skill to perform their own credit analysis often like ratings because they provide a framework for arbitrage.
Moody's supports removing ratings from regulations, according to the firm's July 27 congressional testimony. Another witness, Lawrence White of New York University's Stern School of Business, made the case for dismantling regulation of the raters. Perhaps the White House's spat with S&P will clarify minds. Governments don't need to hold these particular enemies close or worry about their mistakes: they should just release them to fight for influence on their merits.
Editing by Rob Cox and Martin Langfield