It would be easy to pass a law that issuers of securities aren’t allowed to pay ratings agencies. One problem is that if purchasers of securities paid for ratings, the ratings would have to be their secret at least for a while. One might add a provision that ratings be made public after x days for some x.
I don’t think this solves the incentive problem at all. Briefly, I think ratings agencies can decide if a class of financial instruments exists or not and, whoever pays them, have an incentive to make sure it exists by being generous to innovative financial products.
I do think an incentive scheme which would work is almost possible. I’d say no new regulations for old standard instruments like corporate bonds. For rating a not so traditional instrument ratings agencies can be paid only the salary of people who do nothing but rate that instrument plus 20% for overhead.
Now such rules haven’t worked very well for government contractors, but I think that’s the best that can be done.
Obviously this proposal is politically impossible. Aside from financiers and the ratings agencies disinterested observers who consider financial innovation to be socially useful will think it’s a terrible idea.
I respond “OK OK plus 30% for overhead.”