The European Securities and Markets Authority, Esma, on Thursday issued a warning about practices surrounding Collateralised Loan Obligations (CLOs) in the EU. The supervisory body has found potential conflicts of interest and undue influence in the CLO rating process during the 2017-2021 period.
The Big Three credit rating agencies - Fitch Ratings, Moody’s and S&P - are at the centre of this review.
CLOs, known for their complexity and opaqueness, play a pivotal role in the securitisation market. Market participants, including arrangers, managers, and investors, heavily rely on credit ratings to navigate these intricate financial products. It’s these participants, not issuers, who often determine the choice of credit rating agencies for deals, Esma found.
A key concern raised by Esma is the dual role of rating agency analysts, who are involved in both developing rating methodologies and engaging in market outreach. This practice, while beneficial for informed rating processes, risks undue commercial influence on the development of CLO methodologies. Esma’s findings indicate that without stringent controls, the integrity of CLO credit ratings could be compromised.
‘Non-analytical’ information
The report also highlights instances where non-analytical information on various rating methods was shared during market outreach. Rating agencies “ should have in place sufficient safeguards to ensure that changes to their methodologies are based on objective reasons,” Esma said.
Esma regards this as inappropriate, pointing out that feedback on the commercial perception of methodologies could create or enhance conflicts of interest, ultimately affecting the accuracy and independence of credit ratings.
‘Rating shopping’
Potential conflicts of interests, Esma said, “may lead to rating shopping”, where the CLO arranger or manager may select the most favourable credit rating for each CLO tranche depending on their interests.
In response to these findings, Esma has alerted each rating agency involved and plans to implement individual remedial action plans. These plans aim to establish robust safeguards and controls to maintain the integrity of the CLO rating process.
Esma said it has commited to ongoing surveillance of the CLO market. This includes monitoring changes in CLO credit ratings, practices, and methodologies, ensuring they remain objective and independent.
Luxembourg also plays a role in the European CLO market, which was largely led from Ireland and earlier from the Netherlands during the period that Esma investigated.