August 1, 2024 - It has been 15 years since the GFC which ushered in a wave of financial regulatory reform around the world. One main pillar of those reforms was the introduction of risk retention regimes in jurisdictions with active securitization markets. Now the Financial Stability Board (FSB) is taking a step back to evaluate the effects of those reforms and the FSB has launched a consultation report on the topic.
The report focuses on a subset of reforms, namely The International Organization of Securities Commissions (IOSCO) minimum retention recommendations and the Basel Committee on Banking Supervision (BCBS) revisions to prudential requirements for banks’ securitization-related exposures. As market participants are familiar, these reforms were implemented differently in different jurisdictions. Of particular note, federal case law has excluded open-market CLOs from the application of the U.S. risk retention regime. With this report the FSB looks to (1) assess the extent to which the securitization reforms have achieved their financial stability objectives and (2) examine broader effects of the reforms on the functioning/structure of the securitization markets and the real economy.
The FSB’s report has determined that risk retention and higher prudential requirements has enhanced the resilience of securitization markets without strong evidence of material negative side-effects on financing the economy. Despite this determination, the FSB is quick to address the analytical challenges they confronted in assessing the evidence and clarify that they cannot, in many cases, establish a causal link to the reforms and observed outcomes. One particular observed outcome which they plan to further examine is the redistribution of risk from banks to the nonbank sector (NBFI). Banks have gravitated toward higher rated tranches leading to a decrease in banks’ risk weighed asset density – a feature, not a bug, of the financial reforms. The FSB cannot point to any evidence that this redistribution has negatively impacted financial stability but holds the door open that NBFIs may not be well-placed to have assumed those risks (and pointing to its ongoing work around NBFI resilience).
The report focuses on CLOs and the non-government-guaranteed part of the RMBS market in its evaluation. For ease of reference, readers can refer to pages 10-21 for the FSB’s assessment of current securitization market trends, pages 36-50 for the discussion on CLOs, and pages 56-63 for the FSB’s conclusions on the impact of risk retention on the real economy. Perhaps of greatest interest to LSTA members is the FSB’s conclusion that the default rate of CLO tranches post-GFC has been low with no defaults to date of issuances after 2014 despite the rise of cov-lite loans. The FSB acknowledges the positive role of active management of CLO managers in support of this and recognizes the strength of the CLO 2.0 structural features. The report comments on the widespread practice of using risk retention vehicles to attract third party investors to finance the retained portion. The FSB questions whether this practice is fully aligned with the goals of risk retention, citing some possible risks if certain assumptions they make are true, but ultimately has not observed any negative outcomes. Finally, the FSB raises the now ubiquitous question – can NBFIs bear the risks they have assumed? The FSB will be doing more work to answer this question, but so far has not pointed to any evidence of leverage, interconnectedness or liquidity mismatches in NBFI activity which would suggest that they cannot.
The LSTA has shared the consultation with our CLO Committee and is considering whether the LSTA will submit comments. Please reach out to Tess Virmani with any questions or feedback.
The FSB intends to follow up with the final report at the end of the year.
