The proposals indicate the tough stance being taken by the MEP towards the securitization market, though the framework could still be subject to further amendment and negotiation before a final version is agreed upon.
Under the current risk retention framework, ABS issuers, including CLO managers, are required to hold a 5% piece of every deal they issue, to increase the alignment of interests between originators and investors.
In a draft report from the European Parliament’s committee on economic and monetary affairs released on Monday, rapporteur MEP Paul Tang said the risk retention requirement should be increased to 20%, for deals that are both compliant and non-compliant, with the proposed “simple, transparent and standardized” securitization framework.
In an explanatory statement, Tang said enhancing the risk retention requirement would “assure a better alignment of interests” and help avoid “moral hazard and make the securitization market more stable during times of crisis”.
In the document, Tang outlined that the European Banking Authority, the European Securities and Market Authority and the European Insurance and Occupational Pensions Authority would be empowered to draft amendments to the risk retention requirements for different asset classes. This opens up the possibility that, rather than the current flat 5% rule across all ABS instruments, different risk retention rules could be introduced across the breadth of the ABS market.
The draft report will be used as a basis for further discussion in the committee. As such, a great deal of uncertainty remains as to the final outcome of the final regulatory framework. The proposals are still to be finalised by the committee, before being voted on by the wider parliament.
The framework would then be subject to a three way negotiation between the European Parliament, European Commission and European Council, and could be subject to further amendment. Some estimate that a final framework may not be in place until mid-2017.
‘Utterly bonkers’
Market participants have reacted strongly to the proposed measure.
Anna Bak, securitization manager at the Association for Financial Markets in Europe, said the proposals were disappointing.
"Many of our members have expressed concern with the proposals," she said. "Securitization performed well in Europe throughout the crisis, which has been shown by the performance data. The European Commission has also confirmed this. Risk retention already existed in Europe before the crisis, and it has worked well."
"20% risk retention is misplaced. I don't think there is any evidence that this is the right number," she said, adding that the additional steps in the legislative process would be a setback to STS and CRR amendments aimed at revitalising the European securitization market. "We're running out of time," she said.
The CLO market in particular would be badly affected if managers were required to hold 20% of every deal, as it would destroy the arbitrage that managers can achieve between the returns on CLO debt and the cost of sourcing loan collateral. Though the CLO market has pushed to be excluded from securitization definitions, it falls under the proposed regulations.
One CLO manager described the proposal as “utterly bonkers”.
“If a manager had to fill a 20% of the risk requirement on a horizontal basis, they would have to buy 100% of the equity, 100% of the single-Bs, 100% of the double-Bs, and some of the triple-Bs. It’s crazy, it would shut down the market,” he said.
Ashurst partner Cameron Saylor told GlobalCapital the European Parliament was reopening a debate that many thought had already been settled.
“The 5% figure has been accepted almost globally for a long time, since the risk retention rules came in after the financial crisis. The US is also adopting a 5% figure, and this seems to be what people see as the right level,” he said.
A further blow for the CLO industry is that the draft proposals suggest that all ABS originators would be required to be regulated entities. That would exclude many CLO managers and could be a blow to the developing global CLO market, which has experienced increasing levels of cross-Atlantic activity from CLO managers and investors.
“The requirement for originators to be regulated means that all the CLO structures that rely on the originator retention model would find it difficult to qualify,” said Saylor. “It would also make it more difficult for US CLOs to sell into Europe, because most US managers use the manager origination structure.”
Several CLO managers have adopted third party financing structures to get around risk retention rules in the European market. Saylor suggested that if a 20% rule was introduced it could be an “impetus” for more managers to adopt these structures. But he added that it might not make economic sense, given the sheer size of the proposed risk retention piece.
Managers adopting this structure would also need to be careful not to run afoul of the proposed regulation, which states: “The material net economic interest shall not be split among different types of retainers and not be subject to any credit risk mitigation or hedging.”