Risk Retention – Choosing Your Slice of the Securitisation Cake

Securitisation has many charming quirks – depending on your definition of “charming” – and, one year into the UK Securitisation Framework, the 5 per cent rule remains one of its most quietly dramatic. Everyone agrees you must keep a portion of the deal you’re selling, but choosing which slice you keep is where the story gets interesting. Not all 5 per cents are created equal, and some come with far more fireworks than others.

Regulators call it “risk retention”. We prefer the kitchen version: if you’ve cooked the dish, you eat a portion of it yourself. The logic is straightforward enough – sharing the same risks as your investors tends to concentrate the mind wonderfully and discourages you from sending anything undercooked out of the kitchen.

But you can’t simply tuck away 5 per cent in a jar and declare the job done. The framework insists on a specific method, and each one brings its own distinct character – some steady, some bold, and some that require a stronger constitution than others.

The Three Ways to Slice the Cake

Once you accept that you must hold 5 per cent, the next question is how you’d like it served. The rules give you three approved options, each with its own temperament. Think of the capital structure as a very tall, very serious-looking layer cake. A securitisation divides this cake into layers called tranches – each tranche represents a different level of risk and reward, from the safest investors at the top to the most adventurous ones at the bottom.

Your job is to choose which slice of this cake you’re tucking into.

The vertical slice – the “a bit of everything” approach

Here, you take a slim slice that runs from top to bottom through every layer of the cake.

• How it works: You take at least 5 per cent of each tranche that is sold to investors.
• Translation: You hold a small piece of every risk level – the safe senior part, the middling layers, and the high-risk equity at the bottom.
• Character: Calm, balanced, and impeccably well-behaved.
• Effect: Your fate matches the entire structure: if senior investors cheer, you do too; if the riskier layers wobble, you also wobble. It’s the most even-handed form of retention.

The horizontal slice – the “confidence play”

Instead of sampling every layer, you take your whole slice from the very bottom of the cake.

• How it works: You retain the first-loss tranche – the part of the structure where losses hit first.
• Translation: If anything goes wrong with the loans, you absorb the pain before anyone else.
• Character: Bold, exposed, occasionally stressful.
• Effect: You carry the largest share of risk, but if the portfolio performs well, this is the slice with the richest potential returns.

The L-shaped slice – the “best of both” option

Sometimes the bottom layer isn’t big enough to give you the full 5 per cent you’re required to hold.

• How it works: You take the first-loss piece and then top it up with the next riskiest tranches until you reach 5 per cent.
• Translation: A mix-and-match approach: mostly high-risk, with a supporting scoop of the layers above it.
• Character: Practical, slightly improvised, but entirely within the rules.
• Effect: You still take the first losses, but the top-up ensures the numbers add up neatly.

The rules also allow a fourth option: keeping a random 5 per cent of the underlying loans on your own balance sheet. It’s technically allowed, but almost never used, mostly because administering a truly random selection of hundreds of individual assets is far more effort than holding a single structured slice.

Five Important Rules to Consider

Choosing your slice is only the start. The UK framework adds a handful of technical rules that shape how risk retention behaves once the deal is up and running. These aren’t the headline-grabbers, but they keep the whole structure from misbehaving.

The insolvency switch  

If the party holding the 5 per cent goes bust, the deal shouldn’t grind to a halt. So the rules let the retention move to someone else who can hold it.

In essence: if the designated holder suddenly can’t do the job, someone else can step in so the securitisation isn’t left stranded.

Why it matters: older regimes weren’t always clear on this, and “retention limbo” is not a place anyone wants to be.

Hedging: Mostly forbidden, sometimes fine

The basic idea behind risk retention is that you keep the risk. So, the rules don’t allow you to hedge your 5 per cent after the deal is set up – no insuring it away, no clever workarounds.

But: if you hedged the exposure before the securitisation, as part of your normal risk management, and the hedge doesn’t give you a special advantage over investors, it may be allowed.

In essence: you can’t dodge the risk on purpose, but you can keep any sensible protections you already had in place.

The discount rule for NPE deals

Non-Performing Exposures (distressed loans) often have book values that are far higher than what they’re actually worth.

The framework lets you base your 5 per cent on the price you paid for them, not the number on the original loan document.

In essence: if you bought the loans at a discount, your retention is calculated on the discounted amount, which reflects the real economics.

Why it matters: otherwise, your 5 per cent would be wildly inflated and completely unrealistic.

The sole purpose test

The entity holding the retention must be a genuine operating business, not a company set up purely to tick the regulatory box.

To qualify, it needs:

• a business plan,
• money of its own,
• and people who actually make decisions.

In essence: the regulator wants an actual operating company holding the 5 per cent, not a placeholder with a nameplate.

The cherry-picking ban

You can’t load the securitisation with the weaker loans while keeping the stronger ones for yourself – unless you’ve been upfront about it.

In essence: no sneaking the bruised apples into the basket you’re selling and keeping the shiny ones at home.

Why it matters: investors expect the pool to be broadly representative of what the originator keeps on its balance sheet.

The Last Word

Risk retention rarely steals the spotlight, but it remains one of the foundations of trust in securitisation. It answers a simple question investors always have in the back of their minds: do you believe in these assets enough to stay invested yourself?

One year into the UK framework, the rules are clearer, firmer, and – dare we say it – more practical. Pick your slice, hold it properly, and carry on. It’s a small percentage with a surprisingly large job – a quiet reminder that in securitisation, alignment isn’t decorative, it’s what keeps the whole structure upright.