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Summary of the Call for Technical Advice on the Effectiveness of a Minimum Retention Requirement for Securitisations

Core Content

The European Banking Authority (EBA) has been asked by the European Commission to provide technical advice on the effectiveness of the minimum retention requirement for securitisations, as outlined in Article 122a of the Capital Requirements Directive (CRD) amendments. This requirement, known as the 'skin in the game' rule, mandates that credit institutions can only invest in securitisations if the originator, sponsor, or original lender retains a material net economic interest of at least 5% in the securitisation.

The Commission has issued two Calls for Advice, one focusing on the circumstances under which the retention requirement is met and whether further safeguards should be introduced, and the other addressing specific concerns that may undermine the effectiveness of the provision. CEBS, the Committee of European Banking Supervisors, has been tasked with evaluating the retention requirement, but it has not been able to conduct a full analysis from first principles due to time constraints.

Main Viewpoints

• Retention as part of a broader package: Retention is one of several measures aimed at aligning incentives between originators and investors. It is not a complete solution and other measures, such as enhanced disclosure, may be more effective in addressing misalignment issues.

• Natural incentives for originators: Originators have natural incentives to screen, monitor, and service borrowers, such as maintaining client relationships, reputation, and long-term profitability. These incentives may be sufficient to align interests, reducing the need for regulatory intervention.

• Business model impact: The effectiveness of retention may vary depending on the originator's business model. Institutions that originate for securitisation as a primary activity may have less incentive to maintain quality standards, whereas those with a more traditional model may benefit more from retaining interest.

• Equivalence of retention methods: CEBS has identified four methods of meeting the 5% retention requirement:

  • Retaining each tranche sold to investors
  • Retaining interest in revolving exposures
  • Retaining equivalent on-balance sheet exposures
  • Retaining a first loss tranche
    These methods have different advantages and disadvantages, and no single method is universally applicable.

• Potential issues with retention requirement: A significant increase in the retention level could hinder the ability of institutions to achieve capital relief by transferring risk. Additionally, the current exemption for institutions with a risk-weight of 50% or less may create regulatory arbitrage opportunities.

Key Information

• Market behavior: The current market has already incorporated some form of retention, such as through a "seller share" in master trusts, suggesting that the concept is somewhat accepted.

• Additional retention methods: CEBS has identified an alternative retention method known as "L-shaped" retention, which combines first loss and vertical slice retention. However, this method is not recommended due to complexity and the need for more precise quantification.

• Clarification needs: There are several areas that require clarification, including:

  • The definition and application of penalty clauses
  • How interruptions to retention are treated
  • The method of disclosure of retained amounts
  • The nature of hedges allowed for originators
  • The impact of information asymmetry

• Holding period: The length of time an originator holds the underlying assets before securitisation can influence the effectiveness of retention. Longer holding periods may reduce the risk of inadequate screening, while shorter periods may increase the risk of misalignment.

• Reputation and remuneration: Reputation and remuneration structures play a critical role in shaping the behavior of originators and servicers. Poor remuneration can lead to misaligned incentives, especially for servicers who may not act in the best interest of investors.

• International context: The retention requirement is part of a growing international trend, with IOSCO and the US Treasury also advocating for similar measures to encourage better quality lending.

Recommendations

• The 5% retention requirement should be retained, as no single number is universally appropriate for all securitisation structures.
• The effectiveness of the retention requirement should be assessed in conjunction with other European legislation on securitisation.
• The interaction of different policy objectives should be considered when making recommendations.
• The potential for regulatory arbitrage in cross-border groups should be monitored.
• Further clarification is needed on the application of the retention requirement and its associated mechanisms.

Conclusion

The retention requirement is an important tool for aligning incentives in the securitisation market, but it must be implemented carefully to avoid unintended consequences. CEBS recommends maintaining the 5% threshold, preserving all four retention methods, and clarifying the related provisions to ensure the requirement is both effective and proportionate.