Produced for LexisPSL Banking & Finance and in partnership with Alexander Collins and Nick Shiren of Cadwalader, Wickersham & Taft LLP
This Practice Note describes the position as at January 2021
What is risk retention?
Risk retention in the EU and the UK
The risk retention requirement currently applicable in the EU and the UK consists of obligations on:
- an EU or UK (as applicable) institutional investor to ensure that the originator, sponsor or original lender of a securitisation retains at least 5% of the net economic interest of any securitisation in which it invests, and
- one of the originator, sponsor or original lender to retain a net economic interest of at least 5%
This is explained in more detail below.
The objective of the risk retention requirement
The objective of the risk retention requirement is to create an alignment of interests between those of the suppliers of a securitisation, ie sponsors, originators and original lenders, and those of investors. It is sometimes referred to as the requirement for 'skin-in-the-game'.
The introduction of the risk retention requirement reflected the criticism of the securitisation markets following the global financial crisis. There was widespread concern about the 'originate to distribute' model in which banks did not hold the loans that they originated, but repackaged and securitised them. It was thought by global policymakers that some of the participants in the securitisation chain were incentivised to engage in behaviour which, while furthering their own interests, was not in the interests of others in the securitisation chain or of the broader market. In the 'originate to distribute' model lenders did not have an incentive to apply stringent credit granting standards, since they knew that the related risks would eventually be sold to third parties. A consequence of these misaligned incentives or conflicts of interest led to a weakening of due diligence along the securitisation chain. This resulted in poorly-underwritten assets being securitised by originators and those securities being bought by investors who did not always understand the extent of the risks that they were acquiring. The G20 Leaders' statement from the 2009 Pittsburgh Summit therefore recommended that securitisation 'sponsors or originators should retain a part of the risk of the underlying assets, thus encouraging them to act prudently'.
Introduction of risk retention in the EU
A 5% risk retention requirement was first introduced in the EU (including, at the time, the UK) by way of the Capital Requirements Directive II to new securitisations issued on or after 1 January 2011. These provisions were superseded by an equivalent requirement in the Capital Requirements Regulation (EU) No 575/2013 (EU CRR) and similar to those in the EU CRR, in the Solvency II regime in relation to insurers and in the Alternative Investment Fund Managers Directive (AIFMD) regime in relation to certain alternative fund managers.
Commission Delegated Regulation (EU) No 625/2014 (the CRR Risk Retention RTS) supplements and provides further detail in respect of the risk retention requirement in the EU CRR by way of regulatory technical standards including providing further detail on the modes of risk retention, the fulfilment of the retention requirement through a synthetic or contingent form (eg a total return swap (TRS)), and on multiple originators, original lenders, or sponsors.
The European Commission (EC), following review of the various requirements applicable to EU securitisations, published Regulation (EU) 2017/2402 on 28 December 2017 (the EU Securitisation Regulation) and an accompanying Regulation amending the EU CRR (the EU CRR Amendment Regulation). These regulations entered into force on 17 January 2018, superseding the EU CRR, Solvency II and AIFMD risk retention requirements, largely combining requirements applicable to EU investors and creating new requirements in respect of originators, sponsors or original lenders of EU securitisations, and applicable to securitisations, the securities of which are issued (or where no securities are issued, the securitisation positions of which are created) on or after the application date of 1 January 2019.
Article 6(7) of the EU Securitisation Regulation requires the European Banking Authority (EBA) to develop draft regulatory technical standards (Securitisation Regulation RTS) to specify in greater detail the risk retention requirement including the modalities of retaining risk, the measurement of the level of retention, the prohibition of hedging or selling the retained interest and the conditions for retention on a consolidated basis. On 31 July 2018, a final draft of the Securitisation Regulation RTS was published by the EBA. However, the draft Securitisation Regulation RTS have not yet been adopted by the EC. The transitional provisions of the EU Securitisation Regulation provide that until the draft Securitisation Regulation RTS apply, originators, sponsors or the original lender shall apply Chapters I, II and III and Article 22 of the CRR Risk Retention RTS to securitisations the securities of which are issued on or after 1 January 2019.
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Reprinted from: LexisNexis |March 24, 2021
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.