With risk retention, regulators are aiming a gun at their own feet
European policymakers have identified CLOs as a way to help channel credit to SMEs. So the risk retention rule they are planning to implement makes no sense at all.
To begin: a confession. Collateralised loan obligations have never really been a large part of financing for small and medium sized enterprises in Europe. Market advocates might claim CLOs are an important part of corporate financing, but they are mainly referring to deals backed by loans for leveraged buyouts of large businesses, not SMEs.
But policymakers and regulators have said they want Europe to move away from its reliance on bank financing and towards a capital markets model — hence the Capital Markets Union initiative. They’ve also acknowledged that getting credit to SMEs in Europe is a key step to achieving healthy and sustainable economic growth.
Banks, the thinking goes, are too tied down with capital requirements to find SME lending worth the risk. SME financing is a game the banking sector won’t be getting back into any time in the foreseeable future: it’s capital-intensive and, with weak economic growth, it can be risky.
But asset-backed securities, and perhaps especially CLOs, could finance a significant part of the SME lending market in the future.
There aren’t many other alternatives to bank finance available to SMEs. Because of their size, direct access to the capital markets is generally off limits to them.
But a draft regulation on the CLO market from the European Commission, leaked in August, would if implemented put the knife to any hope of an SME CLO market at all comparable to the healthy one the US now has. Moody's rates $23.9bn of outstanding SME CLOs in the US.
The European Commission is expected to release the final rules for CLO risk retention as early as the end of the month, as part of a package of rules that have been in the making for years. The problem is, when it produced its draft regulation, the EC decided to tweak the recommendation previously set forth by the European Banking Authority on risk retention.
This is a thrust of regulation intended to force managers of CLOs to retain some of the paper, so that they have exposure to the same risks as investors, and are incentivised to manage the assets well.
In the EBA’s recommendation, made in December, it is whether the retaining entity has “substance” — finances, employees, capital — that determines whether it is fit to satisfy retention requirements.
That has allowed issuers like GSO Blackstone, as well as smaller issuers in the US, to sell CLOs and put the risk retention bonds, required by regulators, in affiliated entities that indeed have “substance”.
In GSO’s case, the retention entity raised third party capital in the listed market against the retention pieces of its deals. The entity also has employees and buys and sells assets.
But the EC’s draft changes that in a small but drastically significant way. Under the draft law, it is the purpose of the entity's existence that matters — whether or not the entity was set up primarily for the purpose of securitization.
Special purpose vehicles, whether they have ‘substance’ or not, would likely not be able to qualify to hold risk retention pieces. That means the collateral managers themselves would have to take the 5% piece of each deal, finance it and hold capital against it — no more third party capital.
That is a change of words many say could all but bar entrants into the CLO market that aren’t associated with large firms, such as GSO, which have the balance sheet and scale to provide capital against that kind of risk.
To be fair, there aren’t any smaller issuers in Europe’s CLO market at the moment. That is a function partly of regulatory uncertainty, and partly of the economies of scale needed to operate in a loan market that is thin and illiquid.
But should smaller managers begin to enter, in a Europe where capital markets have begun to play a bigger role in finance, smaller credit managers, under the EC draft, would likely have to hold the 5% economic risk of each transaction they sell on their own balance sheets, financing them and holding capital against them.
It’s well known to market players that an incentive already exists for CLO managers, in that regard. CLO managers make their profits by the fees that are inserted between various parts of the capital stack. Typically, this is structured as a ‘senior management fee’ — something like 15bp — which is diverted from cash flows to the manager before money flows to the top-rated tranche of a deal.
Proceeds then, broadly speaking, flow down the capital stack after certain expenses and tests (like the par value and interest coverage tests). The manager then receives a ‘subordinated management fee’ — this time, more like 30bp-40bp — before cash then flows to the equity piece (again, subject to tests, like the reinvestment overcollateralisation test).
Where the potential for a real conflict of interest occurs is in what happens next. At some point, after all classes have been paid, the collateral manager typically receives an incentive fee, say 20% of the remaining proceeds. That means asset managers are incentivised to juice up the yield in a portfolio, potentially by investing in riskier loans.
Now, besides the fact that CLOs have broadly performed as one would expect, and in many cases better, considering the economic stress of the last seven years, that is perhaps where regulators should have concentrated their efforts.
But policymakers and regulators are still sceptical of actively managed securitizations, even though the bonds that caused the crisis, including some RMBS and synthetic CDOs, were static. Hence, the EC left investments like CLOs out of the definition of securitizations eligible for reduced capital requirements — those that qualify as ‘simple, transparent and standardised’.
The draft regulation leaked in August implies a high likelihood that the closure of the originator retention ‘loophole’ will be effected in the final regulation.
In so doing, the EC is set to throw away a potentially valuable tool — in an already small toolbox — for attaining two of European policymakers’ and regulators’ main post-crisis goals: reducing Europe’s reliance on banks for financing and increasing lending to small and medium sized enterprises.
Chances are, the EC thought that it was improving on the EBA’s recommendation when it made the wording change. Hopefully they’ll change their minds before going to print with the final regulation.
Regulators have identified CLOs as an important instrument in achieving these goals. And yet, they seem dead set on smothering a market in Europe that is already little more than warm coals. There’s a decent chance, if the rule changes, that it could help fuel the fire Europe’s economy needs.