The EU Publishes a Report on Credit Rating Practices in the CLO Market


Today’s post is just a very short alert on the publication of a report today by the EU. The report, entitled ‘Thematic Report: EU CLO credit ratings – an overview of Credit Rating Agencies practices and challenges’ is available here. The aim of the report is to examine the rating practices that underlay the development of collateralised loan obligations, with a particular focus on how risk is identified and transmitted within the process. There is also a distinct focus on the stress-testing that the agencies undertake for these products, with ESMA stating in their press release that they ‘expect 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’. Steven Maijoor, the Chair of the Regulator, went further and stated that the regulator’s assessments of the agencies’ practices in this particular sector ‘highlight a number of supervisory concerns and risks associated with risking this asset class’. These supervisory concerns include:

·       The internal organisation of CRAs – specifically regarding sharing information between groups of analysts so that a holistic picture of CLO creditworthiness is reached;

·       The interactions with CLO issuers – issuers can identify which agency provides for the best ratings for a particular tranche, so ‘shopping’ and commercial conflicts are a worry for regulators;

·       Model/third party dependencies leading to potential operational risks – there is a dependency on data provided by third parties, which needs to be thoroughly accounted for;

·       Rating methodologies, modelling risks and commercial influence – because CLO models and methodologies are underpinned by assumptions, regulators want CRAs to be clear on the limitations of their methodologies;

·       The thorough analysis of CLOs – regulators want the CRAs to carefully monitor market trends and perform thorough analyses of the CLOs they rate.

Despite the conflicting messages within the final two issues – ESMA acknowledge that the CLO methodologies are underpinned by assumption, but simultaneously request that CLOs are thoroughly analysed – the majority of the issues raised by ESMA are issues that are consistently raised. The need for the protection of analyst independence, a reduction in commercial conflicts of interest, and a holistic process to examining creditworthiness are all common calls in this sector. What it does tell us is that the EU is attempting to be proactive regarding credit rating regulation in this current climate, perhaps on the back of developments including the ECB dismissing traditional rating cut-off points, and prominent politicians calling for more reform in the wake of the pandemic-induced downgrades. How the EU continues to respond will be interesting.

Keywords – EU, Rating agencies, @finregmatters

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