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
Previous ArticleEC Issues Rule on Technical Information for Solvency II Calculations
PRA published a set of questions and answers (Q&A) covering common queries regarding residential and commercial property valuations, for the purpose of the Capital Requirements Regulation (CRR), during the period of disruption caused by COVID-19 pandemic.
IOSCO proposed updates to its principles for regulated entities that outsource tasks to service providers.
MAS announced that the first phase of the Veritas initiative will commence with the development of fairness metrics in credit risk scoring and customer marketing.
BoE published the Statistical Notice 2020/4 to update the buy-to-let (BTL) Phase 2 and Phase 3 definitions for the Interest Rate Type data item.
FSI published a brief note that examines challenges facing the banking sector as a result of the payment deferral programs put in place to support borrowers affected by the COVID-19 pandemic.
PRA published the policy statement PS14/20, which contains the supervisory statement SS1/20 and the feedback to responses to the consultation paper CP22/19 on expectations for investment by firms in accordance with the Prudent Person Principle, or PPP, as set out in the Investments Part of the PRA Rulebook.
EBA published an opinion following the notification by the French macro-prudential authority, the Haut Conseil de Stabilité Financière (HCSF), of its intention to extend a measure introduced in 2018 on the use of Article 458(9) of the Capital Requirements Regulation (CRR).
As part of a Research Bulletin on the recent policy-relevant work, ECB published an article that examines the lessons learned from past crises for nonperforming loan resolution in the post COVID-19 period.
RBNZ published the financial stability report for May 2020. This review of the financial system in the country highlights that the economic disruption associated with COVID-19 will present challenges to the financial system.
ECB updated the guidance notes for reporting related to the statistics on holdings of securities by reporting banking groups (SHSG).