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Comparison of key U.S. and EU risk retention initiatives: Not exactly eye to eye

 

15 July 2010

Following the approval by the U.S. Senate on July 15 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), risk retention now forms an official part of the U.S. regulatory landscape subject only to President Obama signing the legislation into law.

By way of background, the Dodd-Frank Act contemplates sweeping changes to the regulation of the U.S. financial services sector, including new risk retention requirements intended to address perceived deficiencies in the asset-backed market. It should be noted that the risk retention requirements contemplated by the Dodd-Frank Act are to be made via corresponding regulations. This means that while the introduction of a risk retention regime has been approved in principle in the U.S., the details of the regime are far from settled.

The risk retention related provisions included in the Dodd-Frank Act stand alongside several other regulatory initiatives recently put forward in the U.S., as well as requirements already adopted, and in the process of being implemented, in Europe. Worryingly, there are significant differences between the various initiatives and it is becoming increasing clear that the authorities don't see eye to eye on the retention question.

EU initiatives

By way of background, in Europe, the ABS retention requirements were approved last year as part of a wider package of amendments to the Capital Requirements Directive (such amendments being commonly referred to as "CRD2"). As noted above, the CRD2 provisions are significantly different from the U.S. initiatives in a number of respects. For example, as a starting point, the CRD2 provisions are framed as an investor restriction, rather than as a direct retention obligation on the originator or sponsor. In particular, under the requirements, third party EU regulated credit institutions will be restricted from taking on exposure to the credit risk of a securitization position unless the originator, sponsor or original lender in respect of the relevant securitization explicitly discloses to the institution that such originator, sponsor or original lender will retain a material net economic interest of not less than five percent in the transaction. This means that the CRD2 requirements will apply generally in respect of deals which may involve the acquisition by an EU regulated credit institution (as investor or counterparty) of exposure to the credit risk of a securitization position, regardless of the jurisdiction of origination. As a result, market participants (in the EU and elsewhere) will be unable to ignore the European retention regime if it is necessary or desirable (as a general liquidity point or otherwise) for an EU regulated credit institution to be able to hold the relevant asset-backed securities (or to assume exposure to the credit risk of a relevant securitization position in another capacity, e.g. as counterparty). Given this bottom line, concerns have been raised that certain hard won placeholders for possible accommodations included in the Dodd-Frank Act with respect to deals backed by commercial mortgage loans or "qualified residential mortgages" may mean little in practice if, for example, investors require the European requirements to be satisfied in order to ensure the securities may be later held by EU regulated credit institutions.

It should also be noted that, notwithstanding the intention on the part of the European authorities to create a harmonized retention regime in Europe, cracks in the framework have already started to appear. Just last week the German parliament passed implementing legislation which "gold-plates" the CRD2 requirements by increasing the retention level to 10 percent, effectively increasing the retention requirements in respect of securitizations where it may be desirable for the securities to be held by German credit institutions (which may be a general liquidity point for a large number of transactions). Concerns have been raised that the German legislation creates an even more challenging compliance landscape for market participants.

Other U.S. initiatives

On the U.S. side, the other retention initiatives to note include the proposals put forward by (i) the Securities and Exchange Commission (SEC), to revisit the conditions to ABS issuers' eligibility for "shelf" registration by adding (inter alia) a new risk retention requirement and (ii) the Federal Deposit Insurance Corporation (FDIC), to make its safe harbor for legal isolation of securitized assets from an insolvent sponsor bank conditional upon (inter alia) the retention of risk by the relevant sponsor bank.

While the provisions in the Dodd-Frank Act are consistent with the other U.S. legislative initiatives in that they refer to a five percent minimum interest level and focus primarily on retention by the party which organizes and initiates the securitization by transferring the relevant assets (rather than the originator), the points of departure dominate. For example, whereas the regulations to be made under the powers provided by the Act are intended to operate as a general requirement on the securitizer to retain the required interest in the context of ABS deals generally, the SEC's proposals are framed as a requirement for establishing shelf eligibility and the FDIC's proposals are framed as a condition to the availability of the safe harbor for legal isolation as described above. In addition, whereas the Dodd-Frank Act contemplates that provision will be made for some downward adjustment of the required retention levels if certain (to be) specified underwriting standards are met and for discretion to be held by the relevant authorities to provide in the regulations for certain exemptions, exceptions or alternative holding options in respect of the retention requirements (e.g. for deals backed solely by "qualified residential mortgages" and/or commercial mortgage backed deals), the other initiatives refer to a flat five percent minimum required interest level and provide for general application in respect of a wide range of asset-backed products. With respect to hedging, while the SEC has indicated that certain hedging arrangements should be permitted, both of the Dodd-Frank Act and the FDIC proposals suggest that direct and indirect arrangements may be restricted (although, in the case of the former, full details are left to be determined by corresponding regulation).

It is not entirely clear at this point how the U.S. initiatives are intended to fit together. While the FDIC has indicated that its proposals should be consistent with the SEC's proposals, this is not reflected in the current safe harbor proposals (e.g. there are differences in the holding options and in the restrictions on hedging arrangements). While the Dodd-Frank Act provides for various banking authorities and the SEC to make the corresponding regulations to implement the retention requirements, it is not clear that the SEC and/or the FDIC proposals fall within the legislative powers provided under the Act.

It is also unclear how the retention provisions in the Dodd-Frank Act and the other regulatory retention initiatives are intended to interact with the provisions in the Dodd-Frank Act which will restrict the on-balance sheet principal activities engaged in by commercial banks (the so-called Volcker Rule). The call for retention by banks of principal risk on issued securities would appear to generally contradict the bar on principal investing activities proposed by the Volcker Rule. In addition, there is speculation that the new leverage and risk-based capital standards which are also contemplated by the Dodd-Frank Act (the so-called Collins Amendment) may present challenges with respect to the new retention requirements. Lastly, it is not clear how the concept of retention should operate in the context of FDIC-insured depository institutions given recent statements made by the FDIC (in the context of the covered bond debate) indicating that immediate access to bank assets is a key priority.

Further information

We have produced a detailed summary comparison of the retention provisions included in the Dodd-Frank Act and the other U.S. and EU retention initiatives referred to above, and a document which attempts to address in detail certain frequently asked questions in respect of the EU CRD2 requirements based on the information available at this point.  If you would like to receive a copy of either of these documents, please contact Nicole Rhodes or Holly Adams.  We would also encourage interested clients to get in touch if they have questions about the Dodd-Frank Act, CRD2 or any of the retention initiatives referred to herein.

 

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