FSB publishes final report on G20 reforms: Focus on CLO market
Introduction
The final report by the Financial Stability Board (FSB) on its evaluation of the effects of the G20 Financial Regulatory Reforms on Securitization was published on January 22, 2025. The report focuses on the International Organization of Securities Commissions (IOSCO) minimum retention recommendations and the Basel Committee on Banking Supervision (BCBS) revisions to prudential requirements for bank securitization-related exposures in the securitization markets and this client alert focuses on the report’s analysis and conclusions with respect to the collateralized loan obligation (CLO) market.
Its conclusions do not seem to be materially different from the preliminary findings in its July 2024 interim “consultation report,” which, broadly speaking, stated that its reforms – embodied in, among other places, the EU and UK securitization regulations – have been successful and not constrained the market, something that some market participants may partly disagree with.
The evaluation identifies issues for consideration by national authorities and international bodies, such as the need to monitor risks from recent market developments and the effectiveness of risk retention requirements for risk alignment in CLOs.
The report considers the effectiveness of risk retention requirements for risk alignment in CLOs, given that (i) US open-market broadly syndicated CLOs, which constitute a large part of the global CLO market, do not currently operate under such requirements and (ii) the use of third-party risk financing for CLO structures. In summary, the analyses suggest that the credit risk retention rule, at least in the broadly syndicated CLO market, does not appear to have had a significant impact on the pricing of new CLO tranches. The report does, however, stress that we have not yet been through an entire economic cycle since the 2008 global financial crisis (GFC), and is agnostic about how CLOs issued after the GFC, commonly referred to as "CLOs 2.0," with a predominance of covenant-lite loans, might fare in a stressed environment, and whether we might see fire sales of distressed assets by managers.
Resilience in the CLO markets
The evaluation finds that these reforms, introduced in the aftermath of the GFC, have contributed to the resilience of the securitization market without strong evidence of material negative side-effects on financing to the economy. It argues that the securitization market is more transparent, stating, however, that it has not yet been tested through a full credit cycle. It particularly calls out CLOs, noting that they have grown significantly in recent years, but have not yet experienced a prolonged downturn.
The report highlights what many in the CLO market have known for a while – that the default rate of CLO tranches post-GFC has been low, with no tranches of deals issued after 2014 having experienced defaults.
CLOs 2.0 have higher levels of credit enhancement – test triggers and covenants designed to protect senior tranche holders from losses due to lower collateral quality – and subordination, in part due to re-evaluation by the rating agencies of their requirements in that area. Standard tests refer to the quality of the collateral, interest coverage, and over-collateralization, whereby, if test levels fall below their trigger levels, cash flows are diverted away from equity and mezzanine tranches to pay down the liabilities in order of seniority, which deleverages the CLO with the objective of bringing tests back into compliance.
The report notes that complexity metrics – whereby different capital structures with more tranches usually imply different risk layers, a more complicated waterfall, and difficult loss allocation – do not appear to have been significantly impacted by the post-GFC reforms, as average deal and tranche size have not changed post-GFC.
Redistribution of risks to non-banks
The report notes that the reforms may have contributed to a redistribution of risk from banks to the non-bank financial intermediation (NBFI) sector, although of course NBFIs have penetrated many other segments of wholesale debt finance too, and not just CLOs, so there are many operative factors to consider. Banks have shifted towards higher-rated tranches, driven both by an increase in non-bank financing of the economy and by the growth of non-bank investors in securitization, something which is more evident in the CLO market. However, the financial stability impact of this trend is difficult to assess since it is not always clear if the non-bank entities taking on the risks are well-placed to assume those risks given their funding structure and ability to withstand losses in stress events.
Impact of risk retention rules
The report discusses the 2018 US court ruling that overturned the Dodd Frank US risk retention requirement – which initially took effect in December 2016, requiring CLO managers to retain a five percent interest in the credit risk of the CLOs they managed – in respect of open-market CLOs. Under that ruling, open-market CLO managers are no longer required to retain this interest, although the rule continues to apply to balance-sheet CLO managers.
The court ruling allows for a so-called difference-in-difference analysis, comparing the pricing and risk characteristics of newly issued open-market CLOs (not required to have any mandatory risk retention) to those of balance-sheet CLOs (where the risk retention requirements continue to apply). The report goes on to say that examination of four risk measures – average share of CCC loan buckets, weighted average rating factor (WARF), the degree of over-collateralization, and weighted average spread – exhibited broadly similar trends across cohorts of CLOs both before and after the rule's adoption, as well as before and after the rule's (partial) invalidation.
The report suggests that several potential explanations may exist for the lack of clear evidence on the effect of risk retention and that, given the constraints imposed on CLO managers in the indenture documents through numerous tests on observable portfolio characteristics, it is likely that most of the effect of risk retention on risk-taking would be unobservable or latent.
An interesting piece of feedback included, but not extensively analyzed, in the report is that some respondents argued that managed CLOs should be considered third-party asset managers and therefore should not be subject to risk retention requirements regardless of the open-market/balance-sheet dichotomy.
Finally, the report focuses on the financing of CLO managers' retained risk by third-party investors and notes that it raises questions about the extent to which the objective of risk alignment is fulfilled. It notes that, in many cases, a third-party originator vehicle does not belong to the same corporate group as the CLO manager or have sufficiently robust governance arrangements in place, thereby moving risk to parties not originally envisioned by the IOSCO recommendations and complicating authorities’ efforts to determine who is ultimately exposed to risk retention-related losses. The report goes on to say that more clarity on the conditions for such a practice to ensure risk alignment may be useful.
Investor/manager risk alignment
The report notes factors besides risk retention requirements, which are considered by CLO investors for ensuring risk alignment. It highlights that structural features specific to a CLO, such as how management fees are structured (while CLO managers sometimes receive an incentive fee if equity achieves a specific internal rate of return, the primary source of income for a CLO manager is the management fee, which is largely influenced by the deal's size and, to some degree, performance) and reputational risk, contribute to higher alignment of interests between the manager and investors.
Conclusion
The analysis highlights the resilience trends in the CLO market post-GFC, the impact of the risk retention rules, and the various factors influencing risk alignment between CLO managers and investors. The findings suggest that, while risk retention rules may have some impact on pricing, their effect on observable risk characteristics is limited, and other structural features play a significant role in ensuring risk alignment. In terms of steps going forward, the FSB does say that the evaluation "does not make policy recommendations but identifies certain issues for consideration by relevant national authorities and international bodies." It remains to be seen what effect the report might have in the market.