The European Banking Authority recently published its final draft of the regulatory technical standards in relation to risk retention under the EU Securitisation Regulation. This LawFlash covers some of the key aspects of these draft regulatory technical standards.
Article 6 of the EU Securitisation Regulation requires the originator, sponsor or original lender of a securitisation to retain on an ongoing basis a material net economic interest of not less than 5%, using one of five possible methods.
In addition, certain institutional investors need to verify that the risk retention obligations have been complied with, as part of their due diligence obligations under Article 5 of the EU Securitisation Regulation.
The EU Securitisation Regulation required regulatory technical standards to be prepared in order to set out certain aspects of the risk retention requirements in more detail (the EU Risk Retention RTS). A final draft of the EU Risk Retention RTS was originally published by the European Banking Authority (the EBA) in July 2018, but they were not adopted by the European Commission (the Commission).
In March 2021, the EU Securitisation Regulation was amended as part of the Capital Markets Recovery Package, aimed at supporting recovery from the adverse economic effects of the COVID-19 pandemic (the EU Securitisation Regulation Amendment). The EU Securitisation Regulation Amendment included changes to facilitate securitisations of non-performing exposures (NPEs) and the introduction of an STS (simple, transparent and standardised) framework for on balance sheet synthetic securitisations. In addition, a provision was included that required the risk retainer to take into account any fees that may in practice be used to reduce the effective material net economic interest.
As a result of some of these amendments, the draft EU Risk Retention RTS also had to be revised. The EBA published a consultation paper on 30 June 2021, and a revised final draft of the EU Risk Retention RTS was published on 12 April 2022 (the 2022 Final Draft RTS).
Until the EU Risk Retention RTS come into force, the previous regulatory technical standards put in place under the EU Capital Requirements Regulation (the CRR RTS) apply to securitisations that are within the scope of the EU Securitisation Regulation. However, there has been some uncertainty as some of the aspects of the risk retention requirements under the EU Securitisation Regulation were not covered in the CRR RTS.
Below is a summary of some of the key aspects of the 2022 Final Draft RTS.
Sole Purpose Test
The EU Securitisation Regulation provides that an entity shall not be considered to be an originator for the purposes of the risk retention requirements where it has been established or operates for the sole purpose of securitising exposures. The 2022 Final Draft RTS set out how this “sole purpose” test should be assessed. These factors are as follows:
(a) the relevant entity must have “a strategy and the capacity to meet payment obligations consistent with a broader business model that involves material support from capital, assets, fees or other sources of income, by virtue of which the entity does not rely on the exposures to be securitised, on any interests retained or proposed to be retained… or on any corresponding income from such exposures and interests as its sole or predominant source of revenue”; and
(b) the “responsible decision makers” must “have the necessary experience to enable the entity to pursue the established business strategy, as well as adequate corporate governance arrangements”.
It is worth noting that in the EBA’s analysis with respect to the responses received to the consultation, it states that the wording specifically targets income rather than the composition of the balance sheet, as income better reflects the business model of the retainer.
This test will need to be considered carefully when deciding whether an entity is suitable to act as the risk retainer.
Synthetic and Contingent Forms of Retention
The retained interest is permitted to be held in synthetic or contingent form provided that certain conditions are met. The retained interest must be cash collateralised, except when it is held by certain risk retainers—this exception previously applied only to credit institutions but has now been extended to insurance and reinsurance undertakings.
NPE Securitisations
As a result of the EU Securitisation Regulation Amendment, the material net economic interest may be held by the servicer of an NPE securitisation, provided that it has expertise in servicing exposures of a similar nature to the securitised exposures and has well-documented and adequate servicing policies, procedures and risk management controls. The 2022 Final Draft RTS set out how it can be established that the servicer has the requisite expertise, and requires disclosure of the relevant years of experience to investors.
The EU Securitisation Regulation Amendment also added a provision to the effect that, in the case of NPE securitisations where there is a non-refundable purchase price discount, the retained interest should be in an amount of not less than 5% of the sum of the net value of the securitised NPEs (and, if applicable, the nominal value of any performing securitised exposures). The 2022 Final Draft RTS set out further details of how the net value should be calculated.
In addition, the 2022 Final Draft RTS set out how the retention should be held in circumstances where there are multiple servicers in an NPE securitisation, adding to the previous wording dealing with scenarios where there is more than one originator, original lender or sponsor.
Synthetic Excess Spread
The 2022 Final Draft RTS allow for synthetic excess spread which is subject to capital requirements to be taken into account when calculating the material net economic interest, but only if the risk retention is held by way of the first loss tranche. However, market participants have indicated that this is unlikely to be particularly useful, as in practice this is not aligned with the way that the synthetic excess spread is typically held in SRT (significant risk transfer) transactions.
Transfers of the Retained Interest
The retained interest may generally not be sold (and cannot be subject to any credit risk mitigation or hedging). However, it may be used as collateral for secured funding purposes, and it has been clarified that this includes funding arrangements that involve a sale or transfer, provided that in all cases exposure to the credit risk is not transferred.
There are some narrow exceptions to the prohibition on selling the retained interest, which while limited, are helpful, as such wording was not included in the CRR RTS. Sales are permitted (a) in the event of insolvency of the risk retainer, (b) where the retainer is unable to continue acting as such, for legal reasons beyond its control and that of its shareholders, or (c) in the case of retention on a consolidated basis under Article 14 of the 2022 Final Draft RTS.
Fees
Following the requirement introduced by the EU Securitisation Regulation Amendment that the risk retainer must take into account any fees that may in practice be used to reduce the effective material net economic interest, there are some further provisions on this in the 2022 Final Draft RTS.
It is stated that there should be no arrangements or embedded mechanisms by virtue of which the retained interest would decline faster than the interest transferred. However, amortisation over time as a result of cash flow or allocation of losses will not breach this principle. Fees for services provided by the risk retainer can be paid on a priority basis only if such fees are arm’s length and do not have the effect of reducing the retained interest faster than the transferred interest. These conditions will not be considered to be met where the fees are guaranteed or payable up front in advance of services being provided post-closing, and where the effective material net economic interest after deducting such fees is lower than the required minimum net economic interest. Fees that are contingent on performance are acceptable.
It will be important to consider these requirements carefully to ensure that any fees payable to the risk retainer fall within the scope of what is permitted.
Resecuritisations
Generally, resecuritisations are banned under Article 8 of the EU Securitisation Regulation, but they are permitted in very limited circumstances. The 2022 Final Draft RTS provide that, for such permitted resecuritisations, risk retention is required at each level of the transaction, with some narrow exceptions.
The Recitals to the 2022 Final Draft RTS and the EBA’s analysis with respect to the responses received to the consultation contain some useful wording with respect to transactions funded via ABCP programmes. Under Article 8 of the EU Securitisation Regulation, fully supported ABCP programmes are not considered to be resecuritisations, provided that the underlying transactions are not resecuritisations and the credit enhancement does not create a second layer of tranching at the programme level. The EBA have indicated that a second level of risk retention is not required at transaction level in the case of an ABCP programme that meets these requirements. This appears to resolve a key question that market participants have been considering for some time. However, this will need to be considered carefully in practice as there may still be circumstances where retention would also be required at transaction level, e.g. if a bank is funding the same transaction on its balance sheet.
Adverse Selection
The EU Securitisation Regulation introduced a prohibition on adverse selection of assets, i.e. cherry-picking assets with a higher risk of loss than the retained assets and putting them into the securitisation.
The 2022 Final Draft RTS include provisions setting out how to determine whether assets retained on the balance sheet are comparable to the securitised assets. This analysis should be done at the time of selection, and the originator’s internal policies, procedures and controls will also be relevant in determining whether there has been any adverse selection. Finally, it is clarified that the requirements can still be met if there are no comparable assets left on the originator’s balance sheet, provided that this is clearly disclosed to investors.
Repeal
From the date on which the 2022 Final Draft RTS come into force, the CRR RTS will be repealed (subject to the transitional provisions of the EU Securitisation Regulation for securitisations which remain grandfathered and which will be subject to the previous rules).
The next step is for the 2022 Final Draft RTS to be endorsed by the Commission, and there will also be a “non-objection period” for consideration by the Council of the European Union and the European Parliament. Following the end of that process, and assuming all goes smoothly, the EU Risk Retention RTS will be published in the Official Journal and will come into force 20 days after the date of publication.
In the United Kingdom there is now a separate regime in relation to securitisation. The EU Securitisation Regulation was onshored in the form in effect at the end of the Brexit transition period (31 December 2020) and amended (as so amended, the UK Securitisation Regulation). Since the EU Securitisation Regulation Amendment was put in place after that date, the changes it made to the EU Securitisation Regulation do not apply in the United Kingdom, and since the EU Risk Retention RTS were not finalised before that date, they will also not apply in the United Kingdom.
As a result, there will need to be a separate set of UK risk retention technical standards. It remains to be seen how closely they will be aligned to the EU RTS. In the interim period, the CRR RTS, as onshored into UK law, will apply to securitisations which are within the scope of the UK Securitisation Regulation.
While the UK risk retention requirements may well be similar, they are unlikely to be identical. Consequently, the relevant risk retention rules and the relevant investor due diligence requirements under the EU Securitisation Regulation or the UK Securitisation Regulation, as applicable, will need to be considered carefully where one or more of the entities involved in a securitisation are located in the European Union and in the United Kingdom.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the author, Merryn Craske, or any of the following Morgan Lewis lawyers:
Chicago
Patrick J. Lampe
Philip W. Russell
Jeffrey D. Weinstein
London
Merryn Craske
Julian Goodman
Richard Hanson
Theresa Kradjian
New York
Reed D. Auerbach
Steven H. Becker
Harlyn Bohensky
Matthew P. Joseph
Keith L. Krasney
Steve Levitan
Edmond Seferi
Washington, DC
Asa J. Herald
Cory E. Barry
Jeffrey R. Johnson
Mark R. Riccardi
Paul R. St. Lawrence
Charles A. Sweet
Alex Velinsky