The Capital Requirements Directive1 (“CRD”) was adopted in June 2006, based on the Basel II G-10 Agreement. The purpose of the CRD is to ensure that the regulatory capital requirements for and risk management practices of European banks and investment firms meet the challenges of contemporary markets and products. The CRD addresses how much of their own resources these financial institutions must maintain at all times to cover their particular risks and protect their customers.
On 1 October 2008, the European Commission proposed a number of changes to the CRD to the European Parliament. These changes are intended to address perceived failings in the structured finance markets. While the proposal would introduce amendments on different matters, including large exposures and a “college of supervisors” for all cross-border banks, the amendment that has received the most attention thus far is the proposed retention requirements for certain investment products (the “Retention Amendment”).
Pursuant to the Retention Amendment, it would be cost-prohibitive for credit institutions regulated in the European Union to acquire securitised products and other similar investment products unless either: (a) the originator of the underlying obligations or (b) the entity that has acquired the underlying obligations on their behalf, has retained not less than 5 per cent. in positions with similar risk profile. The Retention Amendment would cover exposures retained by the credit institution after 1 January 2011.
Reason for Amendment
In the FAQ page on the Commission’s website, the Commission has stated that the purpose of the Retention Amendment is to rebuild trust in the market. Specifically, the Commission states:
“We recognise the importance of securitisation in financial markets. Those markets are currently closed not because of this 5 per cent. rule or pending rule but because of mistrust in the market and the rating process. We need to rebuild that trust. And one of the ways to help rebuild that trust is to let market participants have the comfort that in respect of future securitizations those who originate the underlying assets for securitization pools retain a share of the risk. It is important to inject rigour into these markets to instil confidence amongst investors so that these markets can grow again in a safe and sound manner.”
The Retention Amendment
The current form of the Retention Amendment is the result of several months of revised proposals from the Commission. The original proposal in April of this year was in the form of a 15 per cent. floor in regulatory capital relief, meaning that the originator would always have at least a 15 per cent. exposure for regulatory capital purposes for any assets that were later sold to a securitisation vehicle. This proposal was revised during the summer to be a 10 per cent. retention requirement by the originator or issuer in order to be eligible for investment by a European credit institution. The final proposed amendment changed this amount to 5 per cent. retention.
The Retention Amendment has been proposed in the form of new Article 122a to Section 7 of Chapter 2 of the CRD:
“A credit institution shall only be exposed to the credit risk of an obligation or potential obligation or a pool of obligations or potential obligations where it was not involved in directly negotiating, structuring and documenting the original agreement which created the obligations or potential obligations, if:
(a) the persons or entities that directly negotiated, structured and documented the original agreement with the obligor or potential obligor; or alternatively where applicable,
(b) the persons or entities that manage and purchase such obligations or potential obligations directly or indirectly on behalf of the credit institution,
have issued an explicit commitment to the credit institution to maintain, on an ongoing basis, a material net economic interest and in any event not less than 5 per cent. in positions having the same risk profile as the one that the credit institution is exposed to.”
The Retention Amendment only applies vis investors to exposures entered into by entities identified as credit institutions under Directive 2006/48/EC (each, a “Credit Institution”). A Credit Institution is an entity that is authorised to receive deposits from the public within any Member State. Credit Institutions do not include, therefore, pension funds, UCITs funds or other regulated entities that are not also deposit-taking banks.
Negotiation of Obligation or Potential Obligation
The Retention Amendment applies to “an obligation or potential obligation or a pool of obligations or potential obligations” which the Credit Institution “was not involved in directly negotiating, structuring and documenting” (a “Specified Obligation”).
The amendment excludes the following items from being Specified Obligations:
- obligations of central governments or central banks;
- exposures to institutions with a maturity of three months or more for which a credit assessment by an External Credit Assessment Institution has assigned a risk weight of 50% or better;
- obligations of multilateral development banks; and
- syndicated loans or credit default swaps, provided that such instruments are not used to package and/or hedge a Specified Obligation.
“Obligation” is not defined, which means that activities could be affected that were not intended to be caught by the requirement. The scope of Specified Obligations could go beyond just securitisation positions and would possibly include certain corporate credits, certain units or certain shares issued by UCITs and certain investments in funds. Total return swaps and single-name credit default swaps on non-investment grade institutions appear to be caught by the CRD.
Entity With Retention Obligation
There are two categories of entity that are identified as having the retention obligation with respect to a Specified Obligation:
- the entity that negotiated, structured and documented the Specified Obligation (a “Negotiating Party”); or (where applicable),
- the entity that manages and purchases the Specified Obligations, either directly or indirectly, on behalf of the Credit Institution (an “Investment Manager”)
(each, a “Retention Obligor”).
The Retention Amendment appears to clearly put an obligation on either the Negotiating Party for the Investment Obligation or the Investment Manager for the Credit Institution to comply with the Retention Obligation. However, the amendment is not clear as to how these requirements would apply in the situation where an arranger acquires a pool of obligations that have already been negotiated by a third party (e.g., auto leases or credit card receivables). Does this arrangement require the originator of the assets to comply with the Retention Obligation?; this situation may be considered an “indirect” management or purchase by the arranger on behalf of the Credit Institution.
In order for a Credit Institution to acquire an interest in a Specified Obligation, the Retention Amendment would require the Retention Obligor to provide an “explicit commitment” to maintain, on an ongoing basis, a material net economic interest and in any event not less than 5 per cent. in positions having the same risk profile as the Specified Obligation (the “Retention Obligation”).
There is no guidance as to what precisely would be considered an “explicit commitment”. Also, it is not clear how the words “on an ongoing basis” qualify this commitment (i.e., does this require the Retention Obligor to repeat this commitment on an ongoing basis? Or is it sufficient to make a commitment at sale that the Retention Obligor will maintain such commitment during the term of the Specified Obligation?). However, it is apparent that the commitment must be for the entire term of the Specified Obligation.
Another ambiguity exists with respect to the requirement that the Retention Obligation exist for “positions having the same risk profile as the Specified Obligation”. This language suggests that the Retention Obligation does not have to be the exact same exposure as the Specified Obligation. However, while the Retention Obligation may not need to be the exact exposure, the amendment appears to require that, with respect to any credit-tranched obligation, the Specified Obligation would need to include exposure at each level of subordination in order to qualify.
However, it is clear that these amendments would apply to any Specified Obligation issued in an offshore transaction (e.g., a U.S. offering) that is sold to a European Credit Institution.
Other Material Terms of Amendment
The Retention Amendment would only apply to exposures acquired by a Credit Institution after 1 January 2011. In addition, the relevant local regulators would have the authority to “temporarily suspend” its application during “period of general market liquidity stress”.
Notwithstanding the Retention Obligations of the Retention Obligors, Credit Institutions are still required to properly underwrite and maintain adequate records of their investment in a Specified Obligation. If the Credit Institution fails to comply with the requirements under the Retention Amendment, then it will be required to apply a risk weighting of 1250 per cent. to the Specified Obligation.
The financial services industry has expressed concern that the Retention Amendment will further inhibit lending and ultimately drive up the cost of capital at a time when the banks and the regulators are trying to revive the credit markets. There is also a concern that the amendment would place European firms (in particular, smaller European firms) at a competitive disadvantage against credit institutions based outside of Europe. Firms with better access to foreign, non-European markets will have access to cheaper capital; therefore, access to cheaper capital for certain assets will only be available to foreign-based firms and very large European credit institutions.2
Industry responses to the proposed amendments have been published and are available at:
The proposals, together with the accompanying press release and FAQs, can be found at
To be clear, these proposals have not yet been approved by the European Parliament. However, the Commission has urged that the changes be adopted by April 2009. In the meantime, the Commission has not conducted any formal impact analysis for the proposed amendment. This has been a significant concern of the financial services industry as well as the industry groups that represent them. As indicated above, the City of London report from July 2008 gives sufficient evidence that such a regulatory change would likely cause a reduction in financial services in the European Union; the question remains as to what this will cost the average consumer.
Industry groups such as the ESF, SIFMA, BBA, EBF, LIBA and CMSA-Europe are currently making appeals to the Commission and Parliament to reconsider the proposal amendment.