ESMA published a thematic review on the credit ratings of collateralized loan obligations (CLOs) in EU. The assessment provides an overview of CLO rating practices and identifies the main supervisory concerns and medium-term risks in this asset class. The identified issues include credit rating agencies’ (CRAs) internal organization, their interactions with CLO issuers, operational risks, commercial influence on the rating process, and the need for proper analysis of CLOs. The report is based on information collected until March 2020 but it also highlights the impact that COVID-19 may have on CLO methodologies.
It is too early to assess the aggregated consequences of the COVID-19 outbreak as it will depend on the length of the health crisis and on the effects of the associated government interventions. In light of this, ESMA expects CRAs to continue to perform regular stress-testing simulations and to provide market participants with granular information on the sensitivity of CLO credit ratings to key economic variables affected by the pandemic. ESMA identified the following key risks in its thematic review:
- Internal organization of CRAs. The CLO rating process is segmented between a CLO analytical team and a corporate analytical team in all CRAs. A smooth and ongoing exchange of information between internal teams is key to ensure a holistic assessment of CLO creditworthiness. CRAs should ensure the capacity for the timely identification of all inherent risks to CLOs.
- Interactions with CLO issuers. As CLO arrangers and managers can identify which CRA may assign the best ratings for each CLO tranche, it is key that CRAs ensure the independence of their rating process from any influence from their commercial teams and/or arrangers.
- Model or third-party dependencies leading to potential operational risks. The dependency on rating models and data provided by third parties, along with the high automation of processes, present operational risks which need to be monitored by CRAs to avoid potential errors in credit ratings.
- Rating methodologies, modeling risks, and commercial influence. CLO methodologies are underpinned by assumptions and modelling approaches that can impact credit ratings. ESMA highlights the importance of transparency to market participants on the limitations of methodological approaches. In addition, CRAs should ensure that evolutions in CLO methodologies are not influenced by commercial interests.
- Thorough analysis of CLOs. CRAs should continue to monitor market trends and to perform a thorough analysis of all relevant developments in CLO contractual arrangements.
Keywords: Europe, EU, Banking, Securities, Credit Rating Agencies, Collateralized Loan Obligations, Credit Ratings, Modeling Risk, Governance, ESMA
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