Purpose The Office of the Comptroller of the Currency
(OCC),
Board of Governors of the Federal Reserve System (Board), and Federal
Deposit Insurance Corporation (FDIC) (collectively the “agencies”)
are issuing this leveraged lending guidance to update and replace
the April 2001 interagency guidance
1 regarding sound practices for leveraged finance activities
(2001 guidance).
2 The 2001 guidance addressed expectations for the content of credit
policies, the need for well-defined underwriting standards, the importance
of defining an institution’s risk appetite for leveraged transactions,
and the importance of stress-testing exposures and portfolios.
Leveraged lending is an important type of financing for
national and global economies, and the U.S. financial industry plays
an integral role in making credit available and syndicating that credit
to investors. In particular, financial institutions should ensure
they do not unnecessarily heighten risks by originating poorly underwritten
loans.
3 For
example, a poorly underwritten leveraged loan that is pooled with
other loans or is participated with other institutions may generate
risks for the financial system. This guidance is designed to assist
financial institutions in providing leveraged lending to creditworthy
borrowers in a safe-and-sound manner.
Since the issuance of the 2001 guidance, the agencies
have observed periods of tremendous growth in the volume of leveraged
credit and in the participation of unregulated investors. Additionally,
debt agreements have frequently included features that provided relatively
limited lender protection including, but not limited to, the absence
of meaningful maintenance covenants in loan agreements or the inclusion
of payment-in-kind (PIK)-toggle features in junior capital instruments,
which lessened lenders’ recourse in the event of a borrower’s subpar
performance. The capital structures and repayment prospects for some
transactions, whether originated to hold or to distribute, have at
times been aggressive. Moreover, management information systems (MIS)
at some institutions have proven less than satisfactory in accurately
aggregating exposures on a timely basis, with many institutions holding
large pipelines of higher-risk commitments at a time when buyer demand
for risky assets diminished significantly.
This guidance updates and replaces the 2001 guidance in
light of the developments and experience gained since the time that
guidance was issued. This guidance describes expectations for the
sound risk management of leveraged lending activities, including the
importance for institutions to develop and maintain:
- Transactions structured to reflect a sound business
premise, an appropriate capital structure, and reasonable cash flow
and balance sheet leverage. Combined with supportable performance
projections, these elements of a safe-and-sound loan structure should
clearly support a borrower’s capacity to repay and to de-lever to
a sustainable level over a reasonable period, whether underwritten
to hold or distribute.
- A definition of leveraged lending that facilitates
consistent application across all business lines.
- Well-defined underwriting standards that, among other
things, define acceptable leverage levels and describe amortization
expectations for senior and subordinate debt.
- A credit limit and concentration framework consistent
with the institution’s risk appetite.
- Sound MIS that enable management to identify,
aggregate, and monitor leveraged exposures and comply with policy
across all business lines.
- Strong pipeline management policies and procedures
that, among other things, provide for real-time information on exposures
and limits, and exceptions to the timing of expected distributions
and approved hold levels.
- Guidelines for conducting periodic portfolio and
pipeline stress tests to quantify the potential impact of economic
and market conditions on the institution’s asset quality, earnings,
liquidity, and capital.
Applicability This guidance updates and replaces the existing
2001 guidance and forms the basis of the agencies’ supervisory focus
and review of supervised financial institutions, including any subsidiaries
or affiliates. Implementation of this guidance should be consistent
with the size and risk profile of an institution’s leveraged activities
relative to its assets, earnings, liquidity, and capital. Institutions
that originate or sponsor leveraged transactions should consider all
aspects and sections of the guidance.
In contrast, the vast majority of community banks should
not be affected by this guidance as they have limited involvement
in leveraged lending. Community and smaller institutions that are
involved in leveraged lending activities should discuss with their
primary regulator the implementation of cost-effective controls appropriate
for the complexity of their exposures and activities.
4Given the high risk profile
of leveraged transactions, financial institutions engaged in leveraged
lending should adopt a risk-management framework that has an intensive
and frequent review and monitoring process. The framework should have
as its foundation written risk objectives, risk-acceptance criteria,
and risk controls. A lack of robust risk-management processes and
controls at a financial institution with significant leveraged lending
activities could contribute to supervisory findings that the financial
institution is engaged in unsafe-and-unsound banking practices. This
guidance outlines the agencies’ minimum expectations on the following
topics:
- Definition of Leveraged Lending
- General Policy Expectations
- Participations Purchased
- Underwriting Standards
- Valuation Standards
- Pipeline Management
- Reporting and Analytics
- Risk Rating Leveraged Loans
- Credit Analysis
- Problem Credit Management
- Deal Sponsors
- Credit Review
- Stress-Testing
- Conflicts of Interest
- Reputational Risk
- Compliance
Definition of Leveraged
Lending The policies of financial institutions
should include criteria to define leveraged lending that are appropriate
to the institution.
5 For example, numerous definitions of leveraged lending exist
throughout the financial services industry and commonly contain some
combination of the following:
- Proceeds used for buyouts, acquisitions, or capital
distributions.
- Transactions where the borrower’s Total Debt divided
by EBITDA (earnings before interest, taxes, depreciation, and amortization)
or Senior Debt divided by EBITDA exceed 4.0X EBITDA or 3.0X
EBITDA, respectively, or other defined levels appropriate to the industry
or sector.6
- A borrower recognized in the debt markets as a highly
leveraged firm, which is characterized by a high debt-to-net-worth
ratio.
- Transactions when the borrower’s post-financing leverage,
as measured by its leverage ratios (for example, debt-to-assets, debt-to-net-worth,
debt-to-cash flow, or other similar standards common to particular
industries or sectors), significantly exceeds industry norms or historical
levels.7
A financial institution engaging in leveraged lending
should define it within the institution’s policies and procedures
in a manner sufficiently detailed to ensure consistent application
across all business lines. A financial institution’s definition should
describe clearly the purposes and financial characteristics common
to these transactions, and should cover risk to the institution from
both direct exposure and indirect exposure via limited recourse financing
secured by leveraged loans, or financing extended to financial intermediaries
(such as conduits and special purpose entities (SPEs)) that hold leveraged
loans.
General Policy Expectations A financial institution’s credit policies
and procedures for leveraged lending should address the following:
- Identification of the financial institution’s risk
appetite including clearly defined amounts of leveraged lending that
the institution is willing to underwrite (for example, pipeline limits)
and is willing to retain (for example, transaction and aggregate hold
levels). The institution’s designated risk appetite should be supported
by an analysis of the potential effect on earnings, capital, liquidity,
and other risks that result from these positions, and should be approved
by its board of directors.
- A limit framework that includes limits or guidelines
for single obligors and transactions, aggregate hold portfolio, aggregate
pipeline exposure, and industry and geographic concentrations. The
limit framework should identify the related management approval authorities
and exception tracking provisions. In addition to notional pipeline
limits, the agencies expect that financial institutions with significant
leveraged transactions will implement underwriting limit frameworks
that assess stress losses, flex terms, economic capital usage, and
earnings at risk or that otherwise provide a more nuanced view of
potential risk.8
- Procedures for ensuring the risks of leveraged lending
activities are appropriately reflected in an institution’s allowance
for loan and lease losses (ALLL) and capital adequacy analyses.
- Credit and underwriting approval authorities, including
the procedures for approving and documenting changes to approved transaction
structures and terms.
- Guidelines for appropriate oversight by senior management,
including adequate and timely reporting to the board of directors.
- Expected risk-adjusted returns for leveraged transactions.
- Minimum underwriting standards (see “Underwriting
Standards” section below).
- Effective underwriting practices for primary loan
origination and secondary loan acquisition.
Participations Purchased Financial institutions purchasing participations
and assignments in leveraged lending transactions should make a thorough,
independent evaluation of the transaction and the risks in
volved
before committing any funds.
9 They should
apply the same standards of prudence, credit assessment and approval
criteria, and in-house limits that would be employed if the purchasing
organization were originating the loan. At a minimum, policies should
include requirements for:
- obtaining and independently analyzing full credit
information both before the participation is purchased and on a timely
basis thereafter;
- obtaining from the lead lender copies of all executed
and proposed loan documents, legal opinions, title insurance policies,
Uniform Commercial Code (UCC) searches, and other relevant documents;
- carefully monitoring the borrower’s performance throughout
the life of the loan; and
- establishing appropriate risk-management guidelines
as described in this document.
Underwriting Standards A financial institution’s underwriting
standards should be clear, written and measurable, and should accurately
reflect the institution’s risk appetite for leveraged lending transactions.
A financial institution should have clear underwriting limits regarding
leveraged transactions, including the size that the institution will
arrange both individually and in the aggregate for distribution. The
originating institution should be mindful of reputational risks associated
with poorly underwritten transactions, as these risks may find their
way into a wide variety of investment instruments and exacerbate systemic
risks within the general economy. At a minimum, an institution’s underwriting
standards should consider the following:
- Whether the business premise for each transaction
is sound and the borrower’s capital structure is sustainable regardless
of whether the transaction is underwritten for the institution’s own
portfolio or with the intent to distribute. The entirety of a borrower’s
capital structure should reflect the application of sound financial
analysis and underwriting principles.
- A borrower’s capacity to repay and ability to de-lever
to a sustainable level over a reasonable period. As a general guide,
institutions also should consider whether base case cash flow projections
show the ability to fully amortize senior secured debt or repay a
significant portion of total debt over the medium term.10 Also, projections should include one or more realistic downside
scenarios that reflect key risks identified in the transaction.
- Expectations for the depth and breadth of due diligence
on leveraged transactions. This should include standards for evaluating
various types of collateral, with a clear definition of credit risk
management’s role in such due diligence.
- Standards for evaluating expected risk-adjusted returns.
The standards should include identification of expected distribution
strategies, including alternative strategies for funding and disposing
of positions during market disruptions, and the potential for losses
during such periods.
- The degree of reliance on enterprise value and other
intangible assets for loan repayment, along with acceptable valuation
methodologies, and guidelines for the frequency of periodic reviews
of those values.
- Expectations for the degree of support provided by
the sponsor (if any), taking into consideration the sponsor’s financial
capacity, the extent of its capital contribution at inception, and
other motivating factors. Institutions looking to rely
on sponsor support as a secondary source of repayment for the loan
should be able to provide documentation, including, but not limited
to, financial or liquidity statements, showing recently documented
evidence of the sponsor’s willingness and ability to support the credit
extension.
- Whether credit agreement terms allow for the material
dilution, sale, or exchange of collateral or cash flow-producing assets
without lender approval.
- Credit agreement covenant protections, including
financial performance (such as debt-to-cash flow, interest coverage,
or fixed charge coverage), reporting requirements, and compliance
monitoring. Generally, a leverage level after planned asset sales
(that is, the amount of debt that must be serviced from operating
cash flow) in excess of 6X Total Debt/EBITDA raises concerns for most
industries.
- Collateral requirements in credit agreements that
specify acceptable collateral and risk-appropriate measures and controls,
including acceptable collateral types, loan-to-value guidelines, and
appropriate collateral valuation methodologies. Standards for asset-based
loans that are part of the entire debt structure also should outline
expectations for the use of collateral controls (for example, inspections,
independent valuations, and payment lockbox), other types of collateral
and account maintenance agreements, and periodic reporting requirements.
- Whether loan agreements provide for distribution
of ongoing financial and other relevant credit information to all
participants and investors.
Nothing in the preceding standards should be considered
to discourage providing financing to borrowers engaged in workout
negotiations, or as part of a pre-packaged financing under the bankruptcy
code. Neither are they meant to discourage well-structured, standalone
asset-based credit facilities to borrowers with strong lender monitoring
and controls, for which a financial institution should consider separate
underwriting and risk rating guidance.
Valuation Standards Institutions often rely on enterprise value and other
intangibles when (1) evaluating the feasibility of a loan request;
(2) determining the debt reduction potential of planned asset sales;
(3) assessing a borrower’s ability to access the capital markets;
and (4) estimating the strength of a secondary source of repayment.
Institutions may also view enterprise value as a useful benchmark
for assessing a sponsor’s economic incentive to provide financial
support. Given the specialized knowledge needed for the development
of a credible enterprise valuation and the importance of enterprise
valuations in the underwriting and ongoing risk-assessment processes,
enterprise valuations should be performed by qualified persons independent
of an institution’s origination function.
There are several methods used for valuing businesses.
The most common valuation methods are assets, income, and market.
Asset valuation methods consider an enterprise’s underlying assets
in terms of its net going-concern or liquidation value. Income valuation
methods consider an enterprise’s ongoing cash flows or earnings and
apply appropriate capitalization or discounting techniques. Market
valuation methods derive value multiples from comparable company data
or sales transactions. However, final value estimates should be based
on the method or methods that give supportable and credible results.
In many cases, the income method is generally considered the most
reliable. There are two common approaches employed when using the
income method. The “capitalized cash flow” method determines the value
of a company as the present value of all future cash flows the business
can generate in perpetuity. An appropriate cash flow is determined
and then divided by a risk-adjusted capitalization rate, most commonly
the weighted average cost of capital. This method is most appropriate
when cash flows are predictable and stable. The “discounted cash flow”
method is a multiple-period valuation model that converts a future
series of cash flows into current value by discounting those cash
flows at a rate of return (referred to as the “discount rate”) that
reflects the risk inherent therein. This method is most appropriate
when future cash flows are cyclical or variable over time. Both income
methods involve numerous assumptions, and therefore, supporting documentation
should fully explain the evaluator’s reasoning and conclusions.
When a borrower is experiencing a financial downturn or
facing adverse market conditions, a lender should reflect those adverse
conditions in its assumptions for key variables such as cash flow,
earnings, and sales multiples when assessing enterprise value as a
potential source of repayment. Changes in the value of a borrower’s
assets should be tested under a range of stress scenarios, including
business conditions more adverse than the base case scenario. Stress
tests of enterprise values and their underlying assumptions should
be conducted and documented at origination of the transaction and
periodically thereafter, incorporating the actual performance of the
borrower and any adjustments to projections. The institution should
perform its own discounted cash flow analysis to validate the enterprise
value implied by proxy measures such as multiples of cash flow, earnings,
or sales.
Enterprise value estimates derived from even the most
rigorous procedures are imprecise and ultimately may not be realized.
Therefore, institutions relying on enterprise value or illiquid and
hard-to-value collateral should have policies that provide for appropriate
loan-to-value ratios, discount rates, and collateral margins. Based
on the nature of an institution’s leveraged lending activities, the
institution should establish limits for the proportion of individual
transactions and the total portfolio that are supported by enterprise
value. Regardless of the methodology used, the assumptions underlying
enterprise-value estimates should be clearly documented, well supported,
and understood by the institution’s appropriate decision-makers and
risk oversight units. Further, an institution’s valuation methods
should be appropriate for the borrower’s industry and condition.
Pipeline Management Market disruptions can substantially impede the ability
of an underwriter to consummate syndications or otherwise sell down
exposures, which may result in material losses. Accordingly, financial
institutions should have strong risk management and controls over
transactions in the pipeline, including amounts to be held and those
to be distributed. A financial institution should be able to differentiate
transactions according to tenor, investor class (for example, pro-rata
and institutional), structure, and key borrower characteristics (for
example, industry).
In addition, an institution should develop and maintain:
- A clearly articulated and documented appetite for
underwriting risk that considers the potential effects on earnings,
capital, liquidity, and other risks that result from pipeline exposures.
- Written policies and procedures for defining and managing
distribution failures and “hung” deals, which are identified by an
inability to sell down the exposure within a reasonable period (generally
90 days from transaction closing). The financial institution’s board
of directors and management should establish clear expectations for
the disposition of pipeline transactions that have not been sold according
to their original distribution plan. Such transactions that are subsequently
reclassified as hold-to-maturity should also be reported to management
and the board of directors.
- Guidelines for conducting periodic stress tests on
pipeline exposures to quantify the potential impact of changing economic
and market conditions on the institution’s asset quality, earnings,
liquidity, and capital.
- Controls to monitor performance of the pipeline against
original expectations, and regular reports of variances to management,
including the amount and timing of syndication and distribution variances,
and reporting of recourse sales to achieve distribution.
- Reports that include individual and aggregate transaction
information that accurately risk rates credits and portrays risk and
concentrations in the pipeline.
- Limits on aggregate pipeline commitments.
- Limits on the amount of loans that an institution
is willing to retain on its own books (that is, borrower, counterparty,
and aggregate hold levels), and limits on the underwriting risk that
will be undertaken for amounts intended for distribution.
- Policies and procedures that identify acceptable
accounting methodologies and controls in both functional as well as
dysfunctional markets, and that direct prompt recognition of losses
in accordance with generally accepted accounting principles.
- Policies and procedures addressing the use of hedging
to reduce pipeline and hold exposures, which should address acceptable
types of hedges and the terms considered necessary for providing a
net credit exposure after hedging.
- Plans and provisions addressing contingent liquidity
and compliance with the Board’s Regulation W (12 CFR part 223) when
market illiquidity or credit conditions change, interrupting normal
distribution channels.
Reporting and Analytics The agencies expect financial institutions
to diligently monitor higher risk credits, including leveraged loans.
A financial institution’s management should receive comprehensive
reports about the characteristics and trends in such exposures at
least quarterly, and summaries should be provided to the institution’s
board of directors. Policies and procedures should identify the fields
to be populated and captured by a financial institution’s MIS, which
should yield accurate and timely reporting to management and the board
of directors that may include the following:
- Individual and portfolio exposures within and across
all business lines and legal vehicles, including the pipeline.
- Risk rating distribution and migration analysis,
including maintenance of a list of those borrowers who have been removed
from the leveraged portfolio due to improvements in their financial
characteristics and overall risk profile.
- Industry mix and maturity profile.
- Metrics derived from probabilities of default and
loss given default.
- Portfolio performance measures, including noncompliance
with covenants, restructurings, delinquencies, non-performing amounts,
and charge-offs.
- Amount of impaired assets and the nature of impairment
(that is, permanent, or temporary), and the amount of the ALLL attributable
to leveraged lending.
- The aggregate level of policy exceptions and the performance
of that portfolio.
- Exposures by collateral type, including unsecured
transactions and those where enterprise value will be the source of
repayment for leveraged loans. Reporting should also consider the
implications of defaults that trigger pari passu treatment for all
lenders and, thus, dilute the secondary support from the sale of collateral.
- Secondary market pricing data and trading volume,
when available.
- Exposures and performance by deal sponsors. Deals
introduced by sponsors may, in some cases, be considered exposure
to related borrowers. An institution should identify, aggregate, and
monitor potential related exposures.
- Gross and net exposures, hedge counterparty concentrations,
and policy exceptions.
- Actual versus projected distribution of the syndicated
pipeline, with regular reports of excess levels over the hold targets
for the syndication inventory. Pipeline definitions should clearly
identify the type of exposure. This includes committed exposures that
have not been accepted by the borrower, commitments accepted but not
closed, and funded and unfunded commitments that have closed but have
not been distributed.
- Total and segmented leveraged lending exposures,
including subordinated debt and equity holdings, alongside established
limits. Reports should provide a detailed and comprehensive view of
global exposures, including situations when an institution has indirect
exposure to an obligor or is holding a previously sold position
as collateral or as a reference asset in a derivative.
- Borrower and counterparty leveraged lending reporting
should consider exposures booked in other business units throughout
the institution, including indirect exposures such as default swaps
and total return swaps, naming the distributed paper as a covered
or referenced asset or collateral exposure through repo transactions.
Additionally, the institution should consider positions held in available-for-sale
or traded portfolios or through structured investment vehicles owned
or sponsored by the originating institution or its subsidiaries or
affiliates.
Risk Rating Leveraged Loans Previously, the agencies issued guidance
on rating credit exposures and credit rating systems, which applies
to all credit transactions, including those in the leveraged lending
category.
11The risk rating of leveraged loans involves the use of
realistic repayment assumptions to determine a borrower’s ability
to de-lever to a sustainable level within a reasonable period of time.
For example, supervisors commonly assume that the ability to fully
amortize senior secured debt or the ability to repay at least 50 percent
of total debt over a five-to-seven year period provides evidence of
adequate repayment capacity. If the projected capacity to pay down
debt from cash flow is nominal with refinancing the only viable option,
the credit will usually be adversely rated even if it has been recently
underwritten. In cases when leveraged loan transactions have no reasonable
or realistic prospects to de-lever, a substandard rating is likely.
Furthermore, when assessing debt service capacity, extensions and
restructures should be scrutinized to ensure that the institution
is not merely masking repayment capacity problems by extending or
restructuring the loan.
If the primary source of repayment becomes inadequate,
the agencies believe that it would generally be inappropriate for
an institution to consider enterprise value as a secondary source
of repayment unless that value is well supported. Evidence of well-supported
value may include binding purchase and sale agreements with qualified
third parties or thorough asset valuations that fully consider the
effect of the borrower’s distressed circumstances and potential changes
in business and market conditions. For such borrowers, when a portion
of the loan may not be protected by pledged assets or a well-supported
enterprise value, examiners generally will rate that portion doubtful
or loss and place the loan on nonaccrual status.
Credit Analysis Effective underwriting and management of leveraged lending risk is
highly dependent on the quality of analysis employed during the approval
process as well as ongoing monitoring. A financial institution’s policies
should address the need for a comprehensive assessment of financial,
business, industry, and management risks including, whether
- Cash flow analyses rely on overly optimistic or unsubstantiated
projections of sales, margins, and merger and acquisition synergies.
- Liquidity analyses include performance metrics appropriate
for the borrower’s industry, predictability of the borrower’s cash
flow, measurement of the borrower’s operating cash needs, and ability
to meet debt maturities.
- Projections exhibit an adequate margin for unanticipated
merger-related integration costs.
- Projections are stress tested for one or more downside
scenarios, including a covenant breach.
- Transactions are reviewed at least quarterly to determine
variance from plan, the related risk implications, and the accuracy
of risk ratings and accrual status. From inception, the credit file
should contain a chronological rationale for and analysis of all substantive
changes to the borrower’s operating plan and variance from expected
financial performance.
- Enterprise and collateral valuations are independently
derived or validated outside of the origination function, are timely,
and consider potential value erosion.
- Collateral liquidation and asset sale estimates are
based on current market conditions and trends.
- Potential collateral shortfalls are identified and
factored into risk rating and accrual decisions.
- Contingency plans anticipate changing conditions
in debt or equity markets when exposures rely on refinancing or the
issuance of new equity.
- The borrower is adequately protected from interest
rate and foreign exchange risk.
Problem Credit Management A financial institution should formulate
individual action plans when working with borrowers experiencing diminished
operating cash flows, depreciated collateral values, or other significant
plan variances. Weak initial underwriting of transactions, coupled
with poor structure and limited covenants, may make problem credit
discussions and eventual restructurings more difficult for an institution
as well as result in less favorable outcomes.
A financial institution should formulate credit policies
that define expectations for the management of adversely rated and
other high-risk borrowers whose performance departs significantly
from planned cash flows, asset sales, collateral values, or other
important targets. These policies should stress the need for workout
plans that contain quantifiable objectives and measureable time frames.
Actions may include working with the borrower for an orderly resolution
while preserving the institution’s interests, sale of the credit in
the secondary market, or liquidation of collateral. Problem credits
should be reviewed regularly for risk rating accuracy, accrual status,
recognition of impairment through specific allocations, and charge-offs.
Deal Sponsors A financial institution that relies on sponsor support
as a secondary source of repayment should develop guidelines for evaluating
the qualifications of financial sponsors and should implement processes
to regularly monitor a sponsor’s financial condition. Deal sponsors
may provide valuable support to borrowers such as strategic planning,
management, and other tangible and intangible benefits. Sponsors may
also provide sources of financial support for borrowers that fail
to achieve projections. Generally, a financial institution rates a
borrower based on an analysis of the borrower’s standalone financial
condition. However, a financial institution may consider support from
a sponsor in assigning internal risk ratings when the institution
can document the sponsor’s history of demonstrated support as well
as the economic incentive, capacity, and stated intent to continue
to support the transaction. However, even with documented capacity
and a history of support, the sponsor’s potential contributions may
not mitigate supervisory concerns absent a documented commitment of
continued support. An evaluation of a sponsor’s financial support
should include the following:
- the sponsor’s historical performance in supporting
its investments, financially and otherwise;
- the sponsor’s economic incentive to support, including
the nature and amount of capital contributed at inception;
- documentation of degree of support (for example,
a guarantee, comfort letter, or verbal assurance);
- consideration of the sponsor’s contractual investment
limitations;
- to the extent feasible, a periodic review of the
sponsor’s financial statements and trends, and an analysis of its
liquidity, including the ability to fund multiple deals;
- consideration of the sponsor’s dividend and capital
contribution practices;
- the likelihood of the sponsor supporting a particular
borrower compared to other deals in the sponsor’s portfolio; and
- guidelines for evaluating the qualifications of a
sponsor and a process to regularly monitor the sponsor’s performance.
Credit Review A financial institution should have a strong and
independent credit review function that demonstrates the ability to
identify portfolio risks and documented authority to escalate inappropriate
risks and other findings to their senior management. Due to the elevated
risks inherent in leveraged lending, and depending on the relative
size of a financial institution’s leveraged lending business, the
institution’s credit review function should assess the performance
of the leveraged portfolio more frequently and in greater depth than
other segments in the loan portfolio. Such assessments should be performed
by individuals with the expertise and experience for these types of
loans and the borrower’s industry. Portfolio reviews should generally
be conducted at least annually. For many financial institutions, the
risk characteristics of leveraged portfolios, such as high reliance
on enterprise value, concentrations, adverse risk rating trends, or
portfolio performance, may dictate more frequent reviews.
A financial institution should staff
its internal credit review function appropriately and ensure that
the function has sufficient resources to ensure timely, independent,
and accurate assessments of leveraged lending transactions. Reviews
should evaluate the level of risk, risk rating integrity, valuation
methodologies, and the quality of risk management. Internal credit
reviews should include the review of the institution’s leveraged lending
practices, policies, and procedures to ensure that they are consistent
with regulatory guidance.
Stress-Testing A financial institution
should develop and implement guidelines for conducting periodic portfolio
stress tests on loans originated to hold as well as loans originated
to distribute, and sensitivity analyses to quantify the potential
impact of changing economic and market conditions on its asset quality,
earnings, liquidity, and capital.
12 The sophistication of stress-testing practices and sensitivity analyses
should be consistent with the size, complexity, and risk characteristics
of the institution’s leveraged loan portfolio. To the extent a financial
institution is required to conduct enterprise-wide stress tests, the
leveraged portfolio should be included in any such tests.
A financial institution should develop appropriate policies
and procedures to address and to prevent potential conflicts of interest
when it has both equity and lending positions. For example, an institution
may be reluctant to use an aggressive collection strategy with a problem
borrower because of the potential impact on the value of an institution’s
equity interest. A financial institution may encounter pressure to
provide financial or other privileged client information that could
benefit an affiliated equity investor. Such conflicts also may occur
when the underwriting financial institution serves as financial advisor
to the seller and simultaneously offers financing to multiple buyers
(that is, stapled financing). Similarly, there may be conflicting
interests among the different lines of business within a financial
institution or between the financial institution and its affiliates.
When these situations occur, potential conflicts of interest arise
between the financial institution and its customers. Policies and
procedures should clearly define potential conflicts of interest,
identify appropriate risk-management controls and procedures, enable
employees to report potential conflicts of interest to management
for action without fear of retribution, and ensure compliance with
applicable laws. Further, management should have an established training
program for employees on appropriate practices to follow to avoid
conflicts of interest, and provide for reporting, tracking, and resolution
of any conflicts of interest that occur.
Reputational Risk Leveraged lending transactions are often syndicated through
the financial and institutional markets. A financial institution’s
apparent failure to meet its legal responsibilities in underwriting
and distributing transactions can damage its market reputation and
impair its ability to compete. Similarly, a financial institution
that distributes transactions which over time have significantly higher
default or loss rates and performance issues may also see its reputation
damaged.
Compliance The legal and regulatory issues raised by leveraged
transactions are numerous and complex. To ensure potential conflicts
are avoided and laws and regulations are adhered to, an institution’s
independent compliance function should periodically review the institution’s
leveraged lending activity. This guidance is consistent with the principles
of safety and soundness and other agency guidance related to commercial
lending.
In particular, because leveraged transactions often involve
a variety of types of debt and bank products, a financial institution
should ensure that its policies incorporate safeguards to prevent
violations of anti-tying regulations. Section 106(b) of the Bank Holding
Company Act Amendments of 1970
13 prohibits certain forms of product tying
by financial institutions and their affiliates. The intent behind
section 106(b) is to prevent financial institutions from using their
market power over certain products to obtain an unfair competitive
advantage in other products.
In addition, equity interests and certain debt instruments
used in leveraged transactions may constitute “securities” for the
purposes of federal securities laws. When securities are involved,
an institution should ensure compliance with applicable securities
laws, including disclosure and other regulatory requirements. An institution
should also establish policies and procedures to appropriately manage
the internal dissemination of material, nonpublic information about
transactions in which it plays a role.
Interagency
policy statement of March 21, 2013 (SR-13-3).
