On 12 April 2022 the European Banking Authority (“EBA”) published final draft regulatory technical standards relating to risk retention pursuant to Article 6 of the EU Securitisation Regulation1 (the “Final Draft RTS”).
The Final Draft RTS is still to be adopted by the European Commission and will enter into force on the 20th day following its publication in the Official Journal of the European Union. It will replace the current risk retention technical standards (the “CRR RTS”)2 under the EU Capital Requirements Regulation (the “CRR”).3
The publication of the Final Draft RTS marks the culmination of a long process. The EBA published a final draft of the risk retention regulatory technical standards on 31 July 2018 (the “2018 Draft RTS”), but these have not been adopted by the European Commission and so have never come into force.
In the meantime, market participants have been required to apply the risk retention provisions in Article 6 of the EU Securitisation Regulation (“EUSR”), as interpreted by the more detailed guidance in the CRR RTS. As regulators themselves acknowledged,4 this was problematic because the 2018 Draft RTS contained new provisions, such as the definition of a ‘sole purpose’ originator and ‘adverse selection of assets’ requirements that were not addressed in the CRR RTS.
As a result, uncertainty about the final content of the RTS has affected market participants’ level of confidence in structuring risk retention for complex securitisations. This was partly mitigated by the fact that the 2018 Draft RTS preserved, in large part, the substance of the CRR RTS and that many of its new rules, such as the prohibition on a ‘sole purpose’ originator retaining, were already being followed by market participants as a result of informal regulatory guidance.
In 2021 various amendments were made to the EUSR as part of the EU COVID-19 economic recovery plan known as the Capital Markets Recovery Package (the “CMRP”), including amendments to the risk retention provisions for securitisations of non-performing exposures (“NPEs”) and to consider the impact of any fees that may be used to reduce the effective material net economic interest. As a result, the EBA’s mandate in respect of the risk retention RTS was expanded to address the CMRP amendments.
On 30 June 2021 the EBA published a consultation paper (the “Consultation Paper”) containing revised final draft regulatory technical standards relating to risk retention (the “2021 Draft RTS”). The 2021 Draft RTS for the most part followed the 2018 Draft RTS, but with additional provisions primarily relating to the CMRP changes.
The Final Draft RTS largely replicate the 2021 Draft RTS, but also incorporates a number of welcome amendments and clarifications reflecting industry responses to the Consultation Paper. However some long-standing market concerns with the RTS remain unresolved.
This note summarizes (i) the main differences between Final Draft RTS and the 2021 Draft RTS (together with certain proposed changes considered but not adopted); and (ii) the current position in relation to technical standards for risk retention under the UK Securitisation Regulation.5
Principal changes made by the Final Draft RTS to the 2021 Draft RTS
1. Fees payable to retainers
The 2021 Draft RTS raised market concerns because Article 15(2) of the RTS included wording that could be interpreted as requiring fees payable to the retainer on a priority basis (i.e. prior to the senior financing) and which are “guaranteed or payable up-front in any form, in full or in part” to be deducted from the retained interest, even if the fees were set on an arm’s length basis and were otherwise appropriate for the services provided. Structuring, arranging and underwriting fees, as well as fees for credit-enhancement related services would potentially have to be deducted from the recognised retained interest. This appeared to go beyond the policy for assessment of fees, set out in Article 6(1) of the EUSR, that “when measuring the material net economic interest, the retainer shall take into account any fees that may in practice be used to reduce the effective material net economic interest”.
In the Final Draft RTS, the EBA has amended the 2021 Draft RTS to provide that fees linked to services provided pre-closing are excluded from the deduction of fees guaranteed or payable upfront. The EBA did not, however, adopt a wider industry proposal that the deduction should only be applied where guaranteed or upfront fees were dependent on the outstanding amount and/or credit quality of the securitised assets over time. This means that parties structuring securitisations will need to consider whether guaranteed or upfront fees payable to the retainer on a priority basis and which relate to post-closing services in advance of the service being provided should be deducted from the recognised retention amount. Premiums payable in connection with interest rate caps or collars could be an example of this type of fee.
As well as requiring that the fees do not create a preferential claim in the securitisation cash flows that effectively reduces the retained interest faster than the transferred interest, Article 15(2) of the Final Draft RTS contains a more general requirement that “the amount of fees is set on an arm’s length basis having regard to comparable transactions in the market”. It is debatable whether this requirement adds anything to the test that fees should not be structured so as to reduce the retained interest faster than the transferred interest, since an arm’s length fee will generally not have this effect. However, while the ‘arm’s length’ requirement is likely to have a limited scope of application, there may be individual transactions with atypical fees structures where further analysis will be necessary.
2. NPE securitisations
The general scheme of the 2021 Draft RTS is that risk retention requirements as they relate to NPE securitisations should be based on the transaction price rather than the nominal price, by interpreting references to the nominal value of the securitised exposures (or where applicable, of the issued tranches) as references to the ‘net value’ of the non-performing exposures. The ‘net value’ is computed using the amount of the ‘non-refundable purchase price discount’ (“NRPPD”) that would be applied had the retained NPEs been securitised.
The EBA adopted a number of technical drafting suggestions relating to the retention options for NPE securitisations, largely to clarify the method for establishing the NRPPD. Although these clarifications are largely welcome, one comment of the EBA, is, however, potentially problematic. In its analysis of industry responses, the EBA stated that “[i]f there is an upside for the seller in the purchase price discount agreement, this means that the seller may get a refund and, therefore, it does not fit the concept of “non-refundable””. This could be read as meaning that the junior tranche of a NPE securitisation, held by the originator and entitling it to excess / variable returns, would be a ‘refund’ and therefore the transaction would not have a NRPPD. Although this comment was presumably not intended to negate the basic scheme of the net value regime for NPE securitisations, it may give rise to some uncertainty for NPE securitisations structured this way and therefore could benefit from future clarification.
In addition, the EBA has modified Article 2(6)(b) of the Final Draft RTS by specifying that, where an NPE securitisation involves multiple servicers and retention is fulfilled by each servicer, the net economic interest has to be retained by each servicer on a pro rata basis in respect of the net value of the NPEs and the nominal value of the performing exposures which it manages.
3. Change of retainer
A number of industry responses to the consultation on the 2021 Draft RTS suggested that, where retention is fulfilled by a servicer-retainer on a NPE securitisation, transfer of the retained interest to a replacement servicer or other eligible retainer should be permitted at the option of the securitisation’s investors where the servicer’s appointment is terminated as a result of contractual termination provisions.
This reiterated a long-standing market concern about the replacement of retainer provisions in relation to other types of retaining entities in respect of which eligibility derives from contractual appointment by the securitisation (such as collateral managers in CLOs and sponsors appointed to manage ABCP programmes).
In its response and analysis, the EBA reiterated that a change of retainer may occur only in a very limited number of exceptional circumstances. The change of retainer cannot be based on a voluntary decision, but has to be “the necessary and unavoidable consequence due to reasons beyond the control of the retainer itself and its shareholders”. It is debatable whether a termination of the retainer’s appointment because of contractual replacement triggers unrelated to insolvency is a reason ‘beyond the control’ of the retainer and its shareholders. The Final Draft RTS do not contain any definitive resolution of this point.
4. Synthetic excess spread
The CMRP introduced an amendment by which synthetic excess spread (“SES”) is considered an exposure to the securitisation and is subject to capital requirements in accordance with Article 248(1)(e) of the CRR. Article 10(1)(d) of the 2021 Draft RTS proposed allowing an originator retainer to count SES incurring a capital charge under new Article 248(1)(e) of the CRR towards satisfaction of the first loss tranche retention option in Article 6(d)(3) of the EUSR.
Respondents to the Consultation Paper noted that satisfying the retention requirement (after reduction by the exposure value of the SES) via a first loss tranche is likely to be economically unattractive for on-balance sheet synthetic securitisations and SES retention reduction would not meaningfully moderate the effect of the new SES capital charge. Therefore it would be preferable if the new SES capital charge counted towards (i.e. was deducted from) any form of retention, rather than just the first loss retention option.
The EBA did not adopt this proposal and the Final Draft RTS retain the SES provisions substantially as set out in the 2021 Draft RTS.
5. Sole purpose test
Article 6(1) of the EUSR provides that an entity shall not be considered to be an originator where the entity has been established or operates for the sole purpose of securitising exposures.
Article 2(7) of the 2021 Draft RTS sets out a number of criteria which are required to be taken into account for the purposes of assessing whether an entity has been established or operates for the sole purpose of securitising exposures, including that the entity has 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 income, by virtue of which the entity does not rely on the securitised exposures, the retained interest or corresponding income from such exposures and interests as its “sole or predominant” source of revenue.
Responses to the Consultation Paper reflected market concerns that the wording of Article 2(7) of the 2021 RTS was open to possible unintentional interpretations which were inconsistent with the text of Article 6(1) of the EUSR. In particular, the EBA was asked to clarify the drafting to provide that appropriate consideration could be given to the relevant criteria (i.e., that each of the criteria need not be given equal weight, so as to allow for adjustments in weighting where, for example, the relevant entity has been established relatively recently and does not have any material operating history).
Respondents also suggested deleting the words “or predominant” (in “sole or predominant source of revenue”) in order to maintain consistency with the text of Article 6 of the EUSR and to avoid the RTS effectively establishing a different and more stringent test than the test set out in Article 6 of the EUSR.
The EBA did not adopt any of the suggested changes to the ‘sole purpose’ test and has retained the text set out in the 2021 Draft RTS. However, in an indication of its approach to the ‘sole purpose’ test, the EBA also noted that the paragraph “explicitly targets income rather than the composition of the balance sheet, as income better reflects the business model of the retainer”.
6. Cash collateralisation of synthetic/contingent risk retention for non-credit institutions
Article 3(2) of the 2021 Draft RTS provides that where a retainer retains an economic interest in a securitisation through a synthetic or contingent form of retention, the retained interest has to be fully cash collateralised when held by entities other than credit institutions.
The EBA has modified Article 3(2) of the 2021 Draft RTS by extending the exemption from the application of the cash collateralisation requirement to certain investment firms, insurance undertakings and reinsurance undertakings.
7. Comparability of assets transferred to the SSPE
Article 18 of the 2021 Draft RTS gives guidance on the concept of comparability between securitised and non-securitised assets in the context of the prohibition of adverse asset selection set out in Article 6(2) of the EUSR. The Final RTS (in what is now Article 17) contains a number of amendments, substantially as requested in certain of the responses to the Consultation Paper.
8. Drafting clarifications
The Final Draft RTS also includes a number of re-wording adjustments which reflect industry concerns as to ambiguity or inconsistency in certain Articles, including the following:
Retention in the context of ABCP programmes
In relation to the ban on resecuritisation set out in Article 8 of the EUSR, the EBA has modified Recital 8 (now Recital 6) of the Final Draft RTS so that it refers to ABCP programmes other than fully supported ABCP programmes. This usefully clarifies the point that fully supported ABCP programmes do not require risk retention at the transaction level.
Prohibition on selling the retained interest – Article 12(3) of the Final Draft RTS
Recital 10 of the Final Draft RTS provides (as discussed above) that it is possible to change the retainer where either: (i) insolvency proceedings have been commenced against the retainer; or (ii) the retainer is unable to continue acting in that capacity for reasons beyond its control or the control of its shareholders. Article 12(3) of the 2021 Draft RTS has now been amended to track more closely the wording of Recital 1) of the Final Draft RTS.
UK Risk Retention
The 2018 Draft RTS on risk retention were not adopted into UK domestic law by the end of the Brexit transition period and therefore the CRR RTS (as onshored) continue to apply in relation to the UK Securitisation Regulation, until the UK adopts risk retention technical standards. HM Treasury has indicated that the relevant competent authority, the PRA, intends to prioritise work on the UK risk retention technical standards in 2022, ‘insofar as it is possible’.6
All indications are that the UK risk retention technical standards will not radically diverge from the EU rules as set out in the Final Draft RTS. In its report on the functioning of the UK Securitisation Regulation7, HM Treasury was of the view that the risk retention framework broadly works as intended. However HM Treasury considered that ‘there could be merit’ to a number of the proposals made by industry, including: transferring the risk retention holder; allowing eligible servicers to fulfil risk retention requirements in NPE securitisations; and calculation of the risk retention on the transaction price for NPE securitisations.
HM Treasury also saw potential benefits to L-shaped risk retention (i.e. a combination of a vertical slice a first loss tranche) and including excess spread as an element of risk retention; however further work with regulators would be required to ensure that these changes would not negatively impact the alignment of sell side parties’ incentives.
The Final Draft RTS is a welcome step towards finalising risk retention rules for the EU securitisation industry and, importantly, contains no significant unwelcome surprises. This should give market participants greater certainty in structuring risk retention for EU securitisations.
One cloud, however, remains on the EU risk retention horizon. This is the Joint Committee of the ESAs’ Joint Opinion of 26 March 2021, which suggested that the retainer should be required to be an originator, sponsor or original lender located in the EU (where one of these transaction parties is EU-incorporated) in order to qualify as a risk retainer for EUSR purposes. If implemented, this would pose considerable challenges for cross-border securitisations, particularly historic securitisations involving multiple originators in EU and non-EU jurisdictions. The European Commission’s report on the functioning of the EUSR has not yet been finalised, but market participants will hope that the European Commission does not adopt the proposal of the ESAs’ Joint Committee on this point.
1 Regulation (EU) 2017/2402, as amended by Regulation (EU) 2021/557, see link: Final Draft RTS on Risk Retention in securitisation.pdf (europa.eu).
5 Regulation (EU) 2017/2402 as it forms part of UK domestic law as “retained EU law” by operation of the European Union (Withdrawal) Act 2018, as amended, and as amended by the Securitisation (Amendment) (EU Exit) Regulations 2019.