Dechert LLP: Focus on Funds for G20 Securitization Reform

The Financial Stability Board (FSB) has published a consultation on the impact of the G20 regulatory reforms on securitization. Here, John McGrath and Aaron Scott, partners at global law firm Dechert, summarize its findings.

Key Takeaways

• Funds have overtaken banks as the largest issuers of securitizations in the U.S. and Europe.
• The Financial Stability Board will concentrate on funds in its securitization regulatory review.
• CLO risk retention and leveraged loan criteria are identified as areas of risk.
• Specific areas for reform in EU securitization rules have been highlighted.

LONDON, Oct. 31, 2024 /PRNewswire/ -- The Financial Stability Board (FSB) has published a consultation report on the impact of the G20 regulatory reforms on securitization. ¹ The report finds that these reforms have shifted securitization issuance from banks to non-bank financial intermediaries (NBFIs) in Australia, Europe, and the U.S. since 2011.

For the FSB, the growing role of NBFIs in securitization is a double-edged sword. Transferring risk outside the banking sector could diversify and strengthen the financing ecosystem if managed prudently. However, the FSB questions whether NBFIs can handle securitization risks given their funding structures and ability to withstand losses during stress events. It acknowledges that the diverse nature of these entities and their regulatory and funding frameworks suggests there is no one-size-fits-all answer. The FSB plans to continue its work on NBFI resilience and apply these principles to the securitization sector.²

Likely impact on CLO market of an increased focus on funds

The FSB's analysis of the CLO market shows the likely impact of an increased focus on funds.

First, NBFIs are seen as responsible for increased complexity and opacity in both the leveraged loan and CLO markets. In particular, the FSB finds that weaker underwriting standards in the leveraged loan market may lead to higher defaults on loans held by CLOs, which will ultimately lead to lower CLO recovery rates. To address this, the FSB encourages the adoption of the recently published IOSCO good practices for leveraged loans and CLOs.³

Second, CLO managers' preference for "light balance sheets" has led to the creation of risk retention vehicles to attract third-party investors. The FSB's main concerns are that this practice may:

1. Not fully align with the goals of risk retention regulation, as the vehicle often isn't part of the CLO manager's corporate group, thereby shifting risk to parties not originally envisioned.
2. Complicate authorities' efforts to determine who is exposed to risk retention-related losses.
3. Result in leveraged risk retention vehicles subject to high asset volatility, especially where the retained risk consists of first-loss tranches.
4. Lead to concentration risk given the niche nature of these vehicles.

The FSB does not propose any specific remedy for this issue. In this context, it is noteworthy that the FSB finds no material adverse effects from the lack of retention in U.S. open-market CLOs. It may be that the larger concerns are opacity and concentration risk.

Critique of regulatory regime for securitization in Europe

Another focus of the report is the regulatory regime for securitization in Europe. In Europe, some FSB stakeholders attribute a perceived decline in issuance to the implementation of the securitization regulatory regime, which has increased costs for issuers and investors. Although the FSB says there is no empirical evidence to support this claim, it highlights several issues with the European regulatory regime:

1. Burdensome due diligence and disclosure requirements.
2. Overly restrictive Simple, Transparent and Standardized ("STS") securitization regime.
3. Adverse treatment of securitizations under the capital framework for insurers.
4. Bank capital calibration for securitization exposures, which is viewed as overly prudent and exhibiting too high a degree of non-neutrality.

Fund industry organizations such as AIMA have been vocal lobbyists for changes to the EU disclosure regime and for an expansion of the STS label to CLOs. It may be that with the increased focus on funds there is now an opportunity to reset these parts of the framework.

Next steps

The FSB plans to publish its final report by the end of the year. Proposals adopted following the consultation will likely shape the next round of G20 securitization reform.

Dechert & Private Credit

Dechert has advised private credit clients for over 30 years, helping them to innovate and thrive as the industry has grown into a complex and diverse US$1.7 trillion market. We create value on the full spectrum of strategies and sub-strategies, including asset-based, distressed debt, permanent capital, direct lending, subordinated debt, specialty financing, special situations and venture debt. With more than 80% of Private Debt Investor's top 100 private credit firms as clients, we offer market-leading fund formation, financing, regulatory, M&A and tax expertise across the U.S., Europe, the Middle East and Asia.

Footnotes

1. See "Evaluation of the Effects of the G20 Financial Regulatory Reforms on Securitisation: Consultation report". The current regulatory approach to securitization is largely based on the G20 reform agenda set by, among others, the FSB, International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS).
2. See "Enhancing the Resilience of Non-Bank Financial Intermediation: Progress report".
3. See "Leveraged Loans and CLOs Good Practices for Consideration".

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