The EU Securitisation Regulation

Sometimes, one really has no choice but to state the obvious: at this time of political, economic and regulatory uncertainty, the last thing we need is any further event which might disrupt or distort the global capital market or-in the phrase of 2016 – "build a wall" between financial sponsors and investors in different parts of the world.

Unfortunately, as it progresses (thus far, slowly) through the European political process, it seems that the EU Securitisation Regulation may deliver such an unsatisfactory outcome, unless the present direction of travel is altered by political intervention or detailed negotiation (or likely both).

Background and the current position

We have previously published briefings on the progress of the European Commission's proposal for a regulation… "laying down common rules on securitisation and creating a European Framework for simple, transparent and standardised securitisation" (the "Securitisation Regulation"). Our briefing from October 2015 discussed the potential impact of the Commission's draft of the Securitisation Regulation for the managed CLO market. Earlier this year, we summarised the keyissues for the market arising from the report on the Commission's proposal published by the ECON committee of the European Parliament (June 2016). This report was the starting point for negotiations on the proposal  in the European Parliament, prior to the approval of a compromise package by the ECON Committee and a subsequent "first reading" and vote on the proposals in a plenary Parliament session. Parliament's position is then taken into the three-cornered "trilogue" negotiation between the Commission, the Council of Europe (comprising the governments of EU member states) and the Parliament, following which an agreed, single text may emerge. The Council of Europe's final compromise text in relation to the Securitisation Regulation was published in November 2015.

The ECON Committee of the Parliament adopted a compromise text on the Securitisation Regulation on 8 December 2016 (together with a related text in relation to amendments to the EU Capital Requirements Regulation). This text will be subject to a formal reading in the Parliament on 16 January 2017. After this, it is expected that the trilogue process will begin during Q1 2017, and that a political agreement between the EU bodies may emerge by mid-2017 . Though the exact timing of these and subsequent events are uncertain, this implies that the Securitisation Regulation would take effect at some stage during 2019, assuming (as is usual for similar EU legislation) that the Regulation comes into force two years after it is formally published in the EU's Official Journal.

Why is this important?

Shortly after the financial crisis, the EU broke with convention by introducing the "risk retention" for securitisation as part of the "CRD II" package in 2010, well ahead of the United States and other jurisdictions. In fact, as we now know, it has taken the US some years to bring into force a parallel requirement for the risk retention in the US securitisation market. Importantly, however, though there are some differences between the requirements in Europe and the US respectively, there is enough consistency of approach to ensure that sponsors' goal of "dual compliant" marketing in Europe and the United States will be, for the most part, achievable.

Unfortunately, the Securitisation Regulation may change that radically. Key points are set out below.

Increase in the retention

Originally, the EU Parliament Report proposed an extraordinary increase in the level of the risk retention from 5% (net economic interest in the transaction) to 20%, subject to a power for the European Banking Authority (EBA) to adjust this to a lower level either generally or for specific market segments.

Following the lobbying efforts of trade associations and others, the Parliament's compromise text shows some improvement for the industry, but not a maintaining of the current 5% level. In fact, the level of required retention under this text is now 10%, with the exception of the "first loss" (or equity) retention, which would remain at 5%. Hence, a "vertical" retention across each tranche in a securitisation would be required to be no less than 10% of the nominal value of each tranche. And it could get worse; the EBA is empowered to increase the level of retention to 20% "in light of market circumstances" from time to time (under new powers which Parliament proposes should be given in connection with "macro prudential oversight" of the securitisation market).

As  far as US sponsors are concerned, this would effectively mandate a first loss retention if dual compliance is to be obtained (failing which, marketing to EU institutions would have to be avoided). Further, secondary market liquidity for US transactions with a 5% vertical retention could be adversely affected.

If implemented (and, it should be stressed, these measures are all subject to "trilogue" negotiation), this increase appears disproportionate and troubling. Default and loss rates in the managed CLO markets have been low, both before and after the financial crisis. Since the introduction of the risk retention in Europe six years ago, managers/sponsors have duly set aside capital for the 5% risk retention, and reported instances of non-compliance, or unacceptable practices caused by conflicts of interest or other factors, have been negligible or non-existent. The case for change, therefore, is unconvincing, in the CLO markets at least. And the proposal appears still more counter-intuitive when it would, apparently, risk depriving European institutions of the opportunity to invest in good quality, independently managed US transactions, at the very time when acceptable yields for such investors remain elusive.

Originators – Regulatory Restriction

The Parliament's compromise text maintains the position that the "sole purpose" text originally proposed by the Commission should be removed. However, the Parliament continues to propose a more prescriptive text, under which an originator (or a sponsor) must be an EU regulated entity (being an EU credit institution, investment firm or insurance undertaking recognised under the Financial Conglomerates Directive) or another type of entity defined in the Securitisation Regulation for this purpose. Though this now includes a "financial institution" (which may be unregulated in EU) which carries on lending and financial leasing business, the great majority of CLO managers established outside the EU will fail to qualify as an originator or sponsor under the Regulation unless they incorporate a new regulated subsidiary in the EU (which, in view of the future Brexit, would likely have to be in Ireland, Luxembourg or another suitable EU jurisdiction).

If enacted, this restriction would again appear to drive a wedge between the EU and US securitisation markets, including the managed CLO market (notwithstanding the possible inclusion of some non-EU lenders, which might be helpful for some US banks and other US lenders). In particular, originators in US CLO transactions which acquire exposures in the secondary market, before selling them to the issuer, will seemingly be excluded.

Requirement that investors be "institutional investors"

The original Parliament report contained a very restrictive requirement that investors in a securitisation (seemingly wherever that securitisation was established) must be EU regulated firms or funds. Without amendment, this provision appeared to guarantee that the EU securitisation market would be cast adrift from the remainder of the global capital market - a perverse result. Not surprisingly, therefore, the compromise  text contains some relaxation of this restriction, though the position is still far from ideal. The proposal from the Parliament is that an investor established outside the EU must be from a "third country or territory whose supervisory and regulatory requirements are considered [by the European Commission] equivalent to the requirements of the European Union" (according to whichever part of the financial sector is relevant to the activities of a particular institutional investor). This type of "equivalence" provision is becoming increasingly common in European financial sector legislation, but seems out of place in this context. Why should it matter, for example, whether US, Japanese or Swiss pensions or insurance company legislation is considered equivalent to that applying in the European Union, when the relevant entities are participating in a securitisation (assuming none of them is originator, sponsor or original lender) solely as passive investors? One might also speculate about the possibility of "retaliatory" regulation in other jurisdictions if a restriction of this kind were to be implemented, potentially affecting savers and pensioners in multiple jurisdictions, rather than solely banks, investment firms and other investment professionals (as will be the case, for example, under the equivalence regime in MiFID II).

Other requirements

Most of the proposals discussed in our previous briefings, including restrictions on non-EU special purpose entities and the establishment of a new "securitisation data repository", remain in a similar or amended form. Taken together, they would represent significant changes for  securitisations generally and the CLO market specifically, both within and outside Europe.

What next?

Though progress on the Securitisation Regulation has, so far as, appeared to be slow, it seems that political momentum may grow under the Maltese Presidency in the early part of 2017, and that a package of measures may be agreed within a few months. It is also clear that the Parliament's position on key issues is stronger than it may have been historically in relation to other financial sector directives or regulations. It is expected that market participants and trade associates and possibly third country governments will be making lobbying efforts during this period. In our view, the potential implications for the industry demand that such an active approach is taken.