On March 15, 2019, the Japanese Financial Services Agency (the “JFSA”) published final rules and FAQs responding to comments on proposed changes in the regulatory capital requirements applicable to Japanese banks and certain other financial institutions that invest in securitization transactions (respectively, the “JFSA Final Rules”, “JFSA FAQs” and “JFSA Proposed Rules”). The JFSA Final Rules are intended to coordinate risk retention requirements with those in effect in other major financial markets around the world.
The major takeaway is that there is a path forward for CLOs which does not include a Japanese risk retention obligation based on a determination by the affected Japanese investors that the underlying loans were not “inadequately formed.” Thus, the JFSA Final Rules will lead to increased loan and collateral manager due diligence by Japanese investors but will not result in wholesale changes to the CLO market.
1. How do the JFSA Final Rules Differ from the JFSA Proposed Rules?
The JFSA Final Rules impose new requirements upon Japanese banks and certain other regulated Japanese financial institutions (each, an “Affected Investor”) with respect to any “securitization exposure” acquired by such an Affected Investor. Except for a clarification that the Final JFSA Rules apply to all securitizations by amending the definition of “original assets” to include assets that the originator “or any other person” transfers to the securitization, the JFSA Final Rules in large part follow the JFSA Proposed Rules. The JFSA Final Rules define a “securitization exposure” as an exposure related to a “securitization transaction” in which the “credit risk related to the original assets is stratified into two or more exposures that are in the relationship of a senior/subordinated structure, and the whole or part thereof are assigned to a third party”. The JFSA Final Rules require Affected Investors to establish comprehensive due diligence processes and procedures in connection with investing in securitization transactions and, in order to avoid a 1.250% risk weighting for each CLO note held by Affected Investors. In particular, they will need to assure either (1) that the originator owns and will retain Japanese risk retention in the CLO required under Article 248, Paragraph 3 (the “Japanese Risk Retention Requirements”) or (2) that “on the basis of the originator’s involvement in the original assets, the nature or the original assets or any other relevant circumstances” that the assets underlying the CLO “were not inappropriately formed”, a concept that has been expanded to permit Affected Investors to make such determination either with respect to the loans underlying the CLO or that parties “deeply involved” in the origination of the CLO hold risk retention at a level that would satisfy or be in excess of that required by the Japanese Risk Retention Requirements .