ESMA warns on automation, third party dependencies among risks to CLO ratings

The European Securities and Markets Authority (ESMA) published a thematic report on Collateralised Loan Obligations (CLOs) credit ratings in the European Union (EU).

Specific to models and automation, ESMA noted:

  • Model/third party dependencies leading to potential operational risks – the dependency on rating models and data provided by third parties, and the high automation of processes, present operational risks which need to be monitored by CRAs to avoid potential errors in credit ratings;
  • Rating methodologies, modelling 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.

The report also highlights the impact that COVID-19 may have on CLO methodologies. 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. However, the report is based on information collected up until March 2020 and it’s too early to assess the aggregated consequences of the outbreak as it will depend on the length of the health crisis and on the effects of the associated government interventions.

Steven Maijoor, chair of ESMA, said in a statement: “ESMA’s assessment of CLO credit rating practices highlight a number of supervisory concerns and risks associated with rating this asset class and we expect CRAs to monitor these risks and address them as appropriate.”

ESMA’s report provides an overview of CLO rating practices and identifies the main supervisory concerns, and medium-term risks, in the asset class, which 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.

Read the full release

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