A loan is basically a commitment to return the borrowed amount after the time promised when accepting the loan. A credit rating, in layman terms, is a rating made on the basis of the probability that the borrower will pay back the loaned amount within the term provided in the loan agreement, without fail. Thus, a high credit rating would mean that the likelihood of the repayment within the defined term without much problems is high and subsequently, a low credit rating means vice versa. This rating directly has an impact on the chances of an entity being approved for a loan or getting satisfactory terms for a particular loan. These ratings apply only to businesses/governments and provide essential information to retail and institutional investors aiding them in making the vital decisions that whether or not the institutions issuing bonds and fixed-income assets will be able to meet their responsibilities. The imposition of a new rule prohibiting banks from investing in bonds with low credit rating showcased the value of these credit ratings in the market. Since primarily, the purpose was to evade the threat of a firms failing to deliver, the practice was swiftly adapted by other firms and it gradually became the standard to be dependent on on credit ratings.
The assessment for companies and governments is typically done by Credit Rating Agencies (CRAs) which assign letter grades to represent a particular firm’s credit rating. In the act of doing so, they provide a thorough analysis and individual evaluations of their credibility in terms of the probability of loan return within the defined timestamp without defaults. Their primary service is to rate the creditworthiness of firms issuing debt commitments and the suppliers of the original debt. Globally, the credit rating industry is extremely focused with only three major players dominating the whole market, i.e. Moody’s, Standard & Poor’s and Fitch. The Credit Rating Agencies are paid by the entities on the lookout for the evaluation of their credit rating or searching for the credit rating for any of their debt issues. These ratings are defined differently by different CRAs. For example, Standard & Poor’s has a scale starting from AAA (representing ‘excellent’) to D (representing ‘worst’). According to this scale, any debt mechanism below BBB- is regarded to be speculative grade, which means that it is more likely to fail to deliver without defaults.
In 1975, finance organizations looked to lighten the requirements on capital and liquidity necessities enforced by the Securities and Exchange Commission (SEC), resulting in the subsequent birth of Nationally Recognized Statistical Ratings Organizations (NRSRO). The effect of these NRSROs was drastic, as the financial institutions could now fulfill their capital needs by investing it in the assets that got promising ratings by a multiple of these organizations. The reason for this permission was the burden of registration requirements in addition to the need of further regulation of credit ratings industry by the SEC. The exponential growth in demand for ratings services by both the investors and the firms releasing securities, coupled with the overhead of further overseeing the regulation, led to the expansion of this industry. Although credit ratings help both the investors and lenders to recognize the threat associated with the bargain they are to make in the form of an investment or financial asset, over-dependency on credit ratings has led to investors backing off from the possibility of for their individual capability of credit risk analysis. The financial crisis of 2008 and the subsequent euro area debt crisis resulted in the CRAs not being able to live up to expectations, in reply to which the SEC made advancements to reevaluate and reinforce the structure for regulation and administration for the CRAs, with the clear aim of the restoration of market assurance and raise investor safety.
On September 26, 2018, the SEC announced that they were in favor of making alterations to organize the existing provisional exception for the Credit Rating Agencies registered with the SEC as NRSROs. Under the Securities Exchange Act, Rule 17g-5(a)(3) enforced a program for the timely provision of information of critical nature for the purpose of the determination of the credit rating of a structured finance asset to NRSROs which were not appointed by the competent authorities of the structured finance asset. Before the induction of this exception, SEC made a provisional exception to the rule for particular finance products released by people outside of the US, who made trade outside of the legal bounds. However, the Commission then prolonged this exception and the suggested amendments aim to not only solidify the exception, but also to elucidate upon it. It also targets the clarification of similar exceptions in the Securities Exchange Act to bring consistency among them. The civic statement date however, shall remain open for 30 days succeeding the publication of the propositioning issue in the Federal Register.