The European Banking Authority (EBA) published a report, and a short opinion, on how to improve the functioning of the securitization markets, as previously requested by the European Commission. The EBA voiced its support, in general, for the Capital Requirements Regulation (CRR) and provided several recommendations to improve regulations related to risk retention, due diligence, and disclosure. The EBA has provided its views to the European Commission, but further industry consultation looks likely at some point in 2015 before any further regulatory changes are implemented. Of the views expressed in the report and opinion, of particular interest are:
- The EBA’s recommendations regarding the originator approach to risk retention; and
- The EBA’s focus on the importance of harmonizing risk retention regulations across international lines.
Fundamental to the EBA’s approach is the overarching goal of aligning the incentives of securitization sponsors or originators with those of investors and the market at large. With this goal in mind, the EBA expressed concern that the definition of “originator” in CRR Article 4(13) should be narrowed “to reduce the potential misuse of the retention requirements via legal definition loopholes” and to ensure compliance with not only the letter but the spirit of the regulation. (Annex I to the report provides an example of the type of structure with which the EBA is concerned.) As it noted in the opinion accompanying the report, “[t]he EBA 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.” Simply put, the EBA is worried that the current definition of originator leaves too much room for potentially harmful market creativity and fails to ensure sufficient alignment of incentives. While the EBA is concerned with misuse of the definition, it does not appear that the intention is to rein in properly capitalized and structured “originator” entities.
Consistent with the broader trend toward global regulatory harmonization, the EBA spent a significant portion of its report analyzing the differences between the EU and U.S. risk retention rules. The EBA concluded that the lack of consistency between the two could have a deleterious effect on the EU securitization market and therefore recommended that “the retention requirements should be implemented globally in a consistent way.” Compliance with both regulatory regimes, the EBA argued, is essential to promoting efficiency in cross-border transactions—and the greater harmony between the two regimes, the easier dual compliance becomes. Although the report does not detail how such harmonization might be achieved, it outlined the rationale supporting what the EBA hopes will be future attempts at global consistency.
These are just two of the ten recommendations issued by the EBA in its report. In addition to proposing changes to the originator definition and issuing a call to global regulatory harmony, the EBA recommended that a “direct approach” to retention requirements be implemented to supplement the “indirect approach,” affirmed the current due diligence and disclosure requirements and their concomitant sanctions, and explained why it did not favor expanding the number of exemptions, among other things.
Even though the EBA seemed pleased, all-in-all, with the current state of EU securitization regulations, it argued that further changes are needed.
The key “going concerns” of the EBA are, therefore, to address loopholes in the existing regulations which threaten to undermine the spirit, if not the letter, of the regulatory framework (particularly with respect to the alignment of interests for originators and investors), and to address the effects of inconsistencies between the US and EU regimes.
Fundamentally, it is the EBA’s concern over the maintenance of an alignment of interests that shapes its approach to securitization reform. The EBA therefore advises against introduction of an additional “L-Shape” retention option which it considers may, through increased flexibility, reduce the overall effectiveness of the retention requirements in terms of alignment of interests.
Thus, whilst new risk retention options for originators are unlikely, we probably haven’t seen the last of new, consequential rules out of the EU, particularly given the real concern over how to address the differences between the US and EU regimes.