Turlough Galvin and Alan Keating look at the European Commission’s proposed 5 per cent ‘skin in the game’ requirement. Some critics argue that this has long since been coming and is too little, too late, while others argue that this will lead to over-regulation and will place European financial institutions at a distinct competitive disadvantage when compared to institutions based outside the EU.  

Given the current turmoil in the financial markets and the alleged shortcomings of European regulation that led to that turmoil, Charlie McCreevy, European Commissioner for Internal Market and Services, on behalf of the European Commission (the Commission), announced on 1 October 2008 the Commission’s proposals for a draft Directive to amend the Capital Requirements Directive (comprising Directives 2006/48/EC and 2006/49/EC, together, the CRD) in order to reinforce the stability of the financial system, reduce risk exposure, ensure adequate protection of credit interests and improve supervision of banks that operate in more than one EU country (the proposals).  

In Charlie McCreevy’s own words: “These new rules will fundamentally strengthen the regulatory framework for EU banks and the financial system. I believe that they are a sensible and proportionate response to the financial turmoil we are experiencing. Basic rigour, transparency and prudence are key to a healthy and stable banking system”. However, some critics argue that this has long since been coming and is too little, too late, while others argue that this will lead to over-regulation and will place European financial institutions at a distinct competitive disadvantage when compared to institutions based outside the EU.  


To counteract the perceived problems in the structured finance markets, the Commission’s Proposals include improving risk management for securitised products - the repayment of which depends on the performance of a dedicated pool of underlying assets - by tightening the rules that applied heretofore. The Commission wants to address potential conflicts of interest in the ‘originate to distribute’ (OTD) model by aligning the interests of originators, arrangers and investors of the more opaque credit risk transfer instruments by requiring such originators and arrangers to retain a proportion of the risk that is being transferred to investors.  

Prior to the Commission’s publication of the Proposals, Charlie McCreevy commented that "the principle of keeping skin in the game is a good one. I have not heard any strong arguments why it should not be done". However, there has been considerable opposition to the Commission’s proposed amendments to the CRD.  

Member States and the financial services industry have argued that Europe’s securitisation business will simply move offshore or to unregulated investors/credit institutions. While the financial services industry recognises the need for greater transparency and due diligence, there remain concerns that the increased cost of compliance may make securitisation transactions simply uneconomic.  

The principal details of the Proposals, in the context of securitised products, are as follows:

  1. The Retention Requirement

Subject to certain exceptions, an EU credit institution may not 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…” unless the originator or arranger gives “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 Requirement).

The current form of the Retention Requirement is the result of several months of revised proposals put forward by the Commission as a result of intense lobbying by Member States and the financial services industry. The original proposal recommended a 15 per cent retention requirement in April 2008, which was subsequently revised to 10 per cent in June 2008 and again to 5 per cent in October 2008.  

The Retention Requirement applies to two categories of persons or entities, namely those:

  1. “that directly negotiated, structured and documented the original agreement with the obligor or potential obligor; or alternately and where applicable,
  2. that manage and purchase such obligations or potential obligations directly or indirectly on behalf of the credit institution.”

The Retention Requirement is generally understood to mean that the originator or arranger must commit to retaining at least 5 per cent of the credit risk of each tranche in a securitisation that is sold to a credit institution.  

What is not clear from the reading of the Proposals is whether an arranger who acquires a pool of obligations that have already been negotiated by an originator or a number of different originators, for example, loan obligations in the context of a CLO, is required to comply with the Retention Requirement. Would the originator or originators of such receivables (who may be unaware of the CLO) be required to comply with the Retention Requirement? Could the manager of the CLO (who has a contractual arrangement with the issuing vehicle) be said to manage and purchase the obligations indirectly on behalf of an investor?  

It is important to note that the Proposals only apply to a ‘credit institution’ within the meaning of Directive 2006/48/EC relating to the taking up and pursuit of the business of credit institutions and thus, includes an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credit for its own account within any Member State of the EU. Credit institutions do not therefore, include, unregulated investors, UCITS funds, pension funds or other regulated entities that are not also deposit taking banks.  

Consequently, a credit institution that is not regulated in the EU will not come within the ambit of the Proposals (and the CRD), but the Proposals would apply to any obligation issued in an offshore transaction that is sold to a European regulated credit institution. Is this approach in the best interests of Europe’s securitisation industry? Will this ultimately lead to European securitisations being sold to non-European regulated investors who will not be subject to the Proposals in order to reduce the cost of capital to the originators, arrangers and managers? Arguably, the Retention Requirement will push up the cost of capital within the EU which would appear to directly contradict the current perceived goal of injecting capital into and stimulating the financial markets.  

Interestingly, there is no guidance in the Proposals as to what exactly would be considered an ‘explicit commitment’. How would such a commitment by the originator or arranger to the investor be documented? Usually any deal commitments would be between the originator or manager and the issuing vehicle, with no direct contractual commitment between the originator or manager and the investors. In the context of bearer securities, if the investor wishes to sell his securities on the secondary market, how would such a commitment be transferred to a secondary investor?

If the Proposals become law, the Retention Requirement would come into effect in respect of exposures incurred by a credit institution after 1 January 2011. The Retention Requirement does not apply to (i) syndicated loans or credit default swaps where these instruments are not used to package and/or hedge an obligation to which the Retention Requirement would otherwise apply or (ii) claims on or guaranteed by governments, central banks, multilateral development banks and banks rated BBBor above.  

Importantly, the Proposals allow for national competent authorities to temporarily suspend the Retention Requirement during periods of general market liquidity stress. There is no guidance in the Proposals as to what “periods of general market liquidity stress” means, but one would assume that the current illiquidity experienced by credit institutions in the financial market would fall within this carve-out.  

  1. Additional Requirements  

According to the Commission: “A stronger and more rigorous securitisation framework including more rigorous due diligence should contribute towards more responsible underwriting and avoidance of a repeat of the enormous costs that have been borne by investors and financial institutions over the past 18 months.”

It is well accepted that the OTD model has contributed to the current financial turmoil and in particular, the US subprime mortgage market turmoil. Perceived shortcomings with the OTD model include the lack of transparency and due diligence and the role played by credit rating agencies in the evaluation of structured products. The issue of due diligence for securitised bond issues has always been somewhat uncomfortable. Under the Prospectus Directive, an issuing vehicle is the sole party generally responsible for all of the contents of a prospectus. However, historically the issuing vehicle does not itself undertake any due diligence – instead this is carried out by the arranging bank (or originator) and their advisers. It would appear to be sensible that whoever undertakes such due diligence should take responsibility for it as a legal matter – making an issuing vehicle solely responsible in such circumstances makes little sense and encourages a lack of rigour.  

The Commission wants investors to have a thorough understanding of the underlying risks and the complex structural features of securities that they are purchasing to enable informed decisions to be made and detailed up-to-date information to be made available to investors. In particular, the Proposals state that credit institutions would be required to:

  • before investing and on an ongoing basis, demonstrate at all times to its national regulator that it has a “comprehensive and thorough understanding of and have implemented formal policies and procedures for analysing and recording, in writing” the commitment of originators and/or sponsors to maintain a net economic interest and the period for which such commitment is given, the risks, due diligence, structural features (including the preparation, both prior to investing and regularly thereafter, of appropriate stress tests) and collateral valuation methodologies in respect of any securitisation it invests in; and  
  • establish formal procedures for monitoring its securitisation positions on an ongoing basis which, shall include, at a minimum: the exposure type, the length of time the exposures have been held by the originator including the percentage held by the originator for less than two years, the percentage of loans more than 30, 60 and 90 days past due, default rates, prepayment rates, loans in foreclosure, collateral type and occupancy, frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification, frequency distribution of loan to value ratios with band widths that facilitate adequate sensitivity analysis,

(together, the Investor’s Requirements).  

Failure by a credit institution to comply with the Investor’s Requirements will result in it incurring a punitive capital charge, ie. it will be required to apply a risk-weighting charge of 1,250 per cent to the securitisation positions that such an institution holds under the CRD.

To increase disclosure and tighten lending origination standards, the Proposals would require sponsor and originator credit institutions to:  

  • apply the same criteria in originating loans to be securitised as they would do in originating exposures to be held on their own non-trading book; and  
  • disclose to investors the level of their retention commitment and ensure that prospective investors have readily available access to all material underlying data together with such other information that is necessary to conduct comprehensive cash flow and collateral stress tests,  

(together, the Originator’s Requirements and together with the Investor’s Requirements, the Additional Requirements).  

Failure by an originator to comply with the Originator’s Requirements will result in such an originator not being allowed to exclude the securitised exposures from the calculation of its capital requirements under the CRD.  

These Additional Requirements raise many questions, such as: how adequately can the national regulator oversee the investor’s policies and procedures put in place to analyse the various specified aspects of the securitisation position it holds both before investing and on an ongoing basis; such requirements will place a serious impediment on the time frame in which structured finance transactions can be achieved together with increased compliance costs; what happens if an originator becomes bankrupt (i.e., will bankruptcy remote structures now inherit a bankruptcy risk?); and how will such requirements be contractually binding between the investor (and any subsequent investor) and the originator?  

These Additional Requirements would apply to all new securitisations from the date the Directive comes into effect and to existing securitisations where new underlying exposures are added or substituted after that date.  


The Proposals will now pass to the European Parliament and the Council of Ministers for their consideration as apart of the EU’s formal legislative process. The Proposals are expected to be adopted by April 2009.  

As noted above, much concern has been expressed by the financial services industry in respect of the Proposals. In their view such a regulatory change would likely cause a reduction in financial services in the EU and will ultimately drive up the cost of capital at a time when the credit markets need to be invigorated. The Proposals raise many questions and are in some instances vague as to how they can be applied in any practical manner.  

We understand that industry groups are currently appealing to the Commission to reconsider the Proposals. However, noting Charlie McCreevy’s comments at the 7th Annual Finance Services Conference in Brussels on 27 January 2009: “I hope – that the final format is robust, and not amended to a point where it is riddled with loopholes and get out clauses, or rendered so complicated and multifaceted via amendments such that the key measures and disciplines contained in the original proposal can be too easily gamed or circumvented” when referring to the Proposals which the Czech Presidency is now working on with the European Parliament, such appeals may fall on deaf ears.  

What is clear is that the Commission’s Proposals are only the beginning of what is to come in a significant overhaul of the entire Basel II Accord. The absence of any overall gearing cap on bank balance sheets, wholly inadequate and inappropriate risk weightings for AAA rated structured products, over-reliance on external credit rating assessments undertaken by agencies who are paid by the issuer and the absurdities of some mark-to-market requirements when markets are totally illiquid will all come under review by the Commission, as voiced by Charlie McCreevy on 27 January 2009.

This Article first appeared in Finance Dublin (February 2009).