Securities Regulation Daily COVID-19 Market Monitoring Group releases observations on credit ratings
Thursday, July 16, 2020

COVID-19 Market Monitoring Group releases observations on credit ratings

By Rodney F. Tonkovic, J.D.

The SEC's COVID-19 Market Monitoring Group shares initial observations about ratings actions, procyclicality and financial stability issues.

Following the formation of the SEC's COVID-19 Market Monitoring Group, the SEC has announced several initial observations concerning credit ratings actions, procyclicality and financial stability issues. The Group's work on issues related to COVID-19's effects on the markets, issuers, and investors is ongoing, but the Commission believes that sharing these initial observations with the pubic would be helpful.

An initial initiative of the Group has been the exploration of credit assessments and credit rating agency downgrades—and market anticipation of, and responses to, those ratings actions—and their contribution to negative procyclicality in certain circumstances and implications for financial stability. The statement notes that it is coordinating and sharing observations with other members of the global financial regulatory community that are examining the interrelationships between ratings actions, procyclicality and financial stability.

Effects of ratings actions. The first observation concerns the analysis of ratings actions. In response to the pandemic, ratings agencies have made adjustments to the analytical assumptions and other inputs used when assigning and maintaining ratings. The Group warns that these analyses should focus on current circumstances, given the "idiosyncratic" nature of the health and economic effects of COVID-19 and that the role of ratings agencies in the 2008 financial crisis is not an apt analogy. The statement notes that regulators are explicitly prohibited from regulating the substance of credit ratings or how they are determined, so its efforts are focused on, among other matters: 1) understanding how rating agencies are responding to the economic effects of COVID-19, and (2) examining rating agencies’ adherence to their own policies, procedures and methodologies for determining credit ratings.

Cost of debt capital: The statement next observes that cost of debt capital is driven by a wide range of financial and non-financial factors and forces, and ratings downgrades are generally lagging indicators of cost of debt capital. The Group notes that there are perceptions that the procyclical effects of increases in the cost of debt capital are the result of ratings downgrades. Instead, rating agency actions are generally lagging indicators of cost of debt capital because before a downgrade occurs, market participants observe the relevant conditions and circumstances that eventually contribute to the ratings action. The Group recognizes, though, that in certain circumstances an adverse ratings action may have some negative effects on the cost of debt capital.

Bunching. Third, the Group observes that observable bunching just above and below the investment grade level may be attributable to various macroeconomic trends, including policy, regulatory and investor choices. According to the Group, there has been observable segmentation of the credit investment universe for certain types of investors and observable concentration of credit in the area around the line between investment grade credit and below investment grade credit. The statement lists several policy positions and regulatory actions taken since the 2008 crisis that have facilitated easier and predictable credit conditions and incentivized borrowers to optimize their balance sheets to achieve ratings in the low investment grade range.

The diverse credit markets. The next observation states that it is important to take into account the wide and diverse spectrum of our credit markets and all major credit market participant types when considering the effects of credit ratings on market structure, including potential procyclicality of ratings downgrades. The Group says that growth in certain portions of the credit markets has attracted increased regulatory attention, but when considering the credit markets generally, the broad spectrum of credit markets and institutional investor types active in these markets must be considered, including, among others, insurance companies and pensions. With a wide lens, risks and trends across these markets can be identified, monitored, and evaluated.

Bilateral specialty finance. Finally, the procyclical effects of credit ratings used in bilateral specialty finance are also appropriate areas for continued monitoring. While other areas deserve ongoing attention, the Group observes that some types of bilateral financing, short term funding and supply chain financing arrangements continue to rely in various ways on credit ratings and that ratings downgrade or other credit events could result in increased financing costs or reduced access or liquidity pressures on the corporate entity. These scenarios could contribute to negative procyclicality and market disruptions, so the Group believes that these matters are worthy of continued examination.

COVID-19 Market Monitoring Group. The SEC announced the formation of the COVID-19 Market Monitoring Group on April 24, 2020. The temporary, senior-level, cross-divisional group is intended to monitor the effects of COVID-19 on markets and market participants and to work with other regulators and public-sector partners. Submissions on this topic, or other issues relating to COVID-19's effects on the markets may be made to [email protected].

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