Japan Regulators Are Set to Shake Up the U.S. Loan Market

(Bloomberg) -- Japan is poised to issue rules outlining the hoops that banks will need to jump through to continue large-scale buying of bundled U.S. corporate loans.

The Financial Services Agency aims to release the rule for investments in collateralized loan obligations as early as next week, a senior government official said. The regulation due to take force on March 31 will impose onerous capital burdens on CLO investors if originators of the underlying assets don’t retain a stake in them -- unless the buyers can prove the products were made appropriately.

The FSA’s readiness to grant an exemption to the so-called risk-retention rule is good news for the U.S. CLO market at a time when demand is cooling following a record $130.4 billion of issuance in 2018. Yield-starved Japanese banks including Norinchukin Bank have become major CLO buyers, prompting the FSA to scrutinize their strategies and risk management.

While Bloomberg previously reported on the plans for an exemption in January, the FSA has since given further details of what buyers need to do to meet it. The agency will require CLO investors to prove through a multi-step “in-depth analysis” that they are buying nothing inappropriate, according to a draft question-and-answer document circulated to some market participants in February and seen by Bloomberg.

That means CLO arrangers in the U.S. -- where issuance from loans pooled from the open market carries no risk-retention requirement -- may have to do more to help Japanese clients prove the quality of the assets they are purchasing. The FSA often releases a Q&A alongside new regulations to guide affected parties.

Large Japanese financial institutions should be able to meet the FSA’s requirements because of their long track record in the market, said Nana Otsuki, chief analyst at Monex Inc. in Tokyo.

The regulator is trying to ensure that investors understand the risks involved in CLOs they hold, the official said, asking not to be identified because the information isn’t public.

The FSA aims to announce the regulations and Q&A at an early date because enforcement begins at the end of March, a spokesman said. The agency is continuing discussions with financial firms about how to determine whether the underlying assets were created in an appropriate manner, he said.

Based on the draft Q&A, in-depth analysis would require CLO buyers to check things including:

  • credit ratings, market prices and loan performance
  • loan covenants that help to protect investors’ rights
  • originators’ screening standards
  • loan collateral.

Investors will need to fulfill the requirements through “objective documentation” and other means, according to the document.

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