Wednesday, April 21, 2010

The risks of risk retention

Original posted on Lexology:

The House and Senate versions of “financial regulatory reform” include mandatory “risk retention” standards that have received little analysis to date. In general, this legislation could require originators of, and investors in, commercial loans to retain, on an un-hedged basis, at least five percent of the credit risk associated with each of their loan assets.

Applying risk retention guidelines to commercial loans, and commercial loan funds (or CLOs) could significantly impair credit availability for many large U.S. companies. This is particularly important because nearly $1.5 trillion in commercial loans are expected to mature by the end of 2014 (the often referred to “refinancing cliff”) and will need to be refinanced or repaid.

Mandating risk retention standards for creditors that make commercial loans could significantly limit the number of lenders available to make and participate in the corporate loan market. In their broadest application, risk retention standards could apply to not only loan arrangers, but each other initial and secondary lender, effectively eliminating a large part of the secondary market participants who typically do not have the ability to purchase or hold five percent of a large loan. Applying risk retention minimums to commercial loan fund managers or sponsors will effectively limit the number of new funds (such as CLOs) available to buy loans. These funds serve as an important source of liquidity for U.S. businesses and banks looking to arrange and sell portions of commercial loans. Impairment of the formation of future CLOs could have an adverse effect on the ability of the secondary market to help address the refinancing cliff.

A healthy secondary market is necessary to enable banks and financial institutions to spread credit risk to sophisticated investors, reducing the systemic risk associated with concentrated loan holdings. Additionally, a vibrant secondary market helps ensure access to capital for U.S. businesses, while stabilizing the cost of available capital. Given the impending refinancing cliff, imposing further restrictions on a primary driver of capital availability and liquidity in the commercial loan market could deal a damaging blow to a slowly stabilizing market.

Attention ought to be directed to the currently proposed risk retention guidelines to help ensure they are formulated in a manner which supports the financing needs of U.S. companies.

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