The Bank of England (“BOE”) and European Central Bank (the “ECB”) recently published a joint response1 to the report and short opinion issued late last year by the European Bank Authority (“EBA”)2 on how to improve the functioning of the securitization markets, including EU risk retention rules.
In general, the BOE and the ECB have agreed with the approach suggested by the EBA, including the EBA’s view that the second limb of the Originator definition (an entity which purchases exposures from third parties for its own account and then securitizes them) should be narrowed to eliminate any loophole and ensure an alignment of interest between investors and sponsors, originators and original lenders. The BOE and ECB also agreed with the EBA’s suggestion that issuers, sponsors and originators should also be responsible for compliance with risk retention rules (the so-called “direct approach”) and not just investors (the “indirect approach”) as under the existing rules.
Although the recommendations of the EBA, the BOE and ECB are not binding, they remain highly persuasive to the European Commission and provide the market with an indication of what the ultimate regulatory position may be should the European Commission elect to adopt these recommendations.
Two More Voices Added to the Chorus
Concurring with the concerns raised by the EBA in its report (as discussed in our previous Dechert OnPoint: Holiday Gifts from the EBA? ), the BOE and ECB focused on the risk of possible “misalignment of interests of the party underwriting the underlying obligations and those of the final investors”3 which may occur under the second limb of the “Originator” definition (an entity which purchases exposures from third parties for its own account and then securitizes them) and suggested that this portion of the definition be narrowed.
Unfortunately, it is not clear from the BOE /ECB response, the nature and scope of any such change to the definition, although it does appear that the response broadly supports the recommendations made by the EBA – principally Recommendation 6 – to ensure an alignment of interests between originator and investor by emphasizing the importance of complying with both the letter and spirit of the regulation. In the EBA report and opinion, the EBA’s priority was to redress what it perceived as a weakness in the alignment of interest between investors and originators and the EBA focused on specific, limited abuses of the Originator definition (e.g. an Originator which only held the exposures for its account for one business day). The EBA stated in Recommendation 6 that it believes “that the entity claiming to be the ‘originator’ should in principle be of real substance and should always hold some actual economic capital on its assets for a minimum period of time.”4 The markets have generally accepted the view that an Originator which has exposure to the underlying assets and is an entity of substance (and not just a special purpose vehicle) should be able to act as an Originator. This in fact has been the basis on which US CLOs have generally sought to comply with EU risk retention rules and significant changes to the definition may prevent European investors from having exposure to this asset class and prevent a more liquid global market for these securities from developing.
We believe that the BOE and ECB response is focused on limiting abuses and aligning interests as was generally understood to be the EBA focus, and, therefore, we do not view this as a significant change in the regulatory outlook. Moreover, we believe that the types of capitalized manager vehicles which have been developing in response to the recent US risk retention rules are vehicles which are well suited to address the concerns being voiced by European regulators in that they marry decision making on underwriting and asset selection with credit risk. We do note that the BOE and ECB suggested that further consideration should be given to the most appropriate entity to hold the risk retention in non-bank securitizations, which suggests that they have given thought to the difficulty of CLOs and certain other non-bank securitizations to fit within risk retention rules that were drafted for bank securitizations.
Overall, this awareness of the complexities of the CLO market, the focus on alignment of interests and elimination of abuse suggest that the BOE and ECB are supporting the EBA’s approach and not suggesting more significant changes.
More Support for Making the Originator / Sponsor Responsible
The second key issue raised in the BOE/ECB’s recent publication suggests that European regulators are keen to align the risk profile of European investors to that of their American cousins. The proposal to place an additional “direct” obligation on the issuer to verify risk retention compliance (alongside the current “indirect” obligation placed on investors) will effectively mean a shift in the risk profile of risk retention. The proposal also suggests that the investors as part of their due diligence relating to risk retention could rely on attestations by the sponsor or originator. Although the proposals will undoubtedly help to harmonize the structure of risk retention provision (and will, no doubt, be welcomed by investors in the market), it will increase the time, legal costs and risks of issuers.