You can see why risk retention is an intuitively appealing idea. If you think of securitization as banks selling loans to investors who are blindly buying based on a credit rating, then one thing you can do is at least make the banks keep some "skin in the game".
Obviously, that’s not how it works. But in the case of banks securitizing their own loan books, at least, it’s easy enough to see why you might like the idea of risk retention. The market has certainly come to accept it as standard practice.
But the scramble that followed the ESAs’ clarification of their interpretation of the sole purpose test this week shows some of the limitations of the concept.
Outside CLOs, non-bank lenders and orphan loan pools are among those most exposed to the non-compliance after the changes. Particularly in the latter case, the need for risk retention is less clear.
What does seem pretty clear that the possibility for collateral damage from something primarily targeted at the CLO market was not fully thought through.
If the ESAs do not offer any further clarification, it will likely place EU investors at a further disadvantage.
For deals with EU originators, the bottom line is that you have to find ways to work around the problem, as has already been illustrated in the CLO market. But for deals outside the EU, this is probably just another reason not to bother with EU compliance — particularly if EU investors are only a portion of the order book.
GlobalCapital understands discussions are ongoing between the market and the regulators about the issue. Meanwhile the whole thing could be upended by the Commission’s proposal, which is due in June.
Risk retention isn’t going anywhere, but there could certainly be more to come on the sole purpose test.