Risk retention rules — colloquially called "skin in the game" requirements — mandate that securitizers retain a portion of the credit risk from transactions they create and sell to investors. The rules were introduced as part of post-financial-crisis regulatory reform (Dodd-Frank Act in the U.S., EU Securitisation Regulation in Europe) to address the misaligned incentives that contributed to the deterioration in mortgage underwriting quality prior to 2008.
The core insight behind risk retention is straightforward: if originators can sell 100% of the credit risk from loans they originate, they have limited incentive to maintain underwriting quality. By requiring originators to retain at least 5% of the credit risk — whether through horizontal (first-loss) retention, vertical (pro-rata slice) retention, or eligible L-shaped structures — regulators force originators to bear the consequences of poor loan quality, incentivizing better underwriting.
In the U.S., the risk retention rules — jointly issued by six federal agencies — took effect in 2015 for most securitization types and in 2016 for CLOs (after years of controversy and legal challenge). CLO managers fought hard against risk retention requirements, arguing that they are intermediaries rather than "originators" of the underlying loans. After extensive litigation, CLO managers were ultimately subject to risk retention requirements, which have been met through various structures.
The most commonly used retention methods include: the "vertical slice" (retaining 5% of each note tranche and 5% of the equity), the "horizontal slice" (retaining 5% of the deal in the most subordinate piece, typically the equity), and the "L-shaped" structure (a combination of horizontal and vertical retention). For CMBS, the risk retention rules imposed particular challenges because the traditional B-piece buyer already fulfilled a similar function — the rules created uncertainty about whether B-piece purchases counted as compliant retention.
From a credit investor's perspective, risk retention is generally positive — it reduces the information asymmetry between originators and investors, signals originator confidence in deal quality, and creates alignment between the parties. However, retention requirements add complexity, cost, and capital requirements for securitizers, affecting the economics and volume of securitization activity in affected markets.