[Federal Register Volume 78, Number 56 (Friday, March 22, 2013)]
[Notices]
[Pages 17766-17776]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2013-06567]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket ID OCC-2011-0028]
FEDERAL RESERVE SYSTEM
[OP-1438]
FEDERAL DEPOSIT INSURANCE CORPORATION
Interagency Guidance on Leveraged Lending
AGENCY: The Office of the Comptroller of the Currency (OCC), Department
of the Treasury; Board of Governors of the Federal Reserve System
(Board); and the Federal Deposit Insurance Corporation (FDIC).
ACTION: Final guidance.
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SUMMARY: The OCC, Board, and the FDIC (collectively, the ``agencies'')
are issuing final guidance on leveraged lending. This guidance outlines
for agency-supervised institutions high-level principles related to
safe-and-sound leveraged lending activities, including underwriting
considerations, assessing and documenting enterprise value, risk
management expectations for credits awaiting distribution, stress-
testing expectations, pipeline portfolio management, and risk
management expectations for exposures held by the institution. This
guidance applies to all financial institutions supervised by the OCC,
Board, and FDIC that engage in leveraged lending activities. The number
of community banks with substantial involvement in leveraged lending is
small; therefore, the agencies generally expect community banks to be
largely unaffected by this guidance.
DATES: This guidance is effective on March 22, 2013. The compliance
date for this guidance is May 21, 2013.
FOR FURTHER INFORMATION CONTACT:
OCC: Louise A. Francis, Commercial Credit Technical Expert, (202)
649-6670, [email protected]; or Kevin Korzeniewski,
Attorney, Legislative and Regulatory Activities Division, (202) 649-
5490, 400 7th Street SW., MS 7W-2, Washington, DC 20219.
Board: Carmen Holly, Supervisory Financial Analyst, Policy Section,
(202) 973-6122, [email protected]; Robert Cote, Senior Supervisory
Financial Analyst, Risk Section, (202) 452-3354, [email protected];
or Benjamin W. McDonough, Senior Counsel, Legal Division, (202) 452-
2036, [email protected]; Board of Governors of the Federal
Reserve System, 20th and C Streets NW., Washington, DC 20551.
[[Page 17767]]
FDIC: Thomas F. Lyons, Senior Examination Specialist, Division of
Risk Management Supervision, (202) 898-6850, [email protected]; or
Gregory S. Feder, Counsel, Legal Division, (202) 898-8724,
[email protected]; 550 17th Street NW., Washington, DC 20429.
SUPPLEMENTARY INFORMATION:
I. Background
On March 30, 2012, the agencies requested public comment on the
joint Proposed Guidance on Leveraged Lending (the proposed guidance)
with the comment period closing on June 8, 2012.\1\ The agencies have
reviewed the public comments, and are now issuing final guidance (final
guidance) that includes certain modifications discussed in more detail
in section II of this SUPPLEMENTARY INFORMATION.
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\1\ See 77 FR 19417 ``Proposed Guidance on Leveraged Lending''
dated March 30, 2012 at https://www.federalregister.gov/articles/2012/03/30/2012-7620/proposed-guidance-on-leveraged-lending.
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As addressed in the final guidance, the agencies expect financial
institutions to properly evaluate and monitor underwritten credit risks
in leveraged loans, to understand the effect of changes in borrowers'
enterprise values on credit portfolio quality, and to assess the
sensitivity of future credit losses to these changes in enterprise
values.\2\ Further, in underwriting such credits, financial
institutions should ensure borrowers are able to repay credits when
due, and that borrowers have sustainable capital structures, including
bank borrowings and other debt, to support their continued operations
through economic cycles. Financial institutions also should be able to
demonstrate they understand the risks and the potential impact of
stressful events and circumstances on borrowers' financial condition.
Recent financial crises underscore the need for financial institutions
to employ sound underwriting, to ensure the risks in leveraged lending
activities are appropriately incorporated in the allowance for loan and
lease losses and capital adequacy analyses, monitor the sustainability
of their borrowers' capital structures, and incorporate stress-testing
into their risk management of leveraged loan portfolios and
distribution pipelines. Financial institutions unprepared for such
stressful events and circumstances can suffer acute threats to their
financial condition and viability. This final guidance is intended to
be consistent with sound industry practices and to expand on recent
interagency issuances on stress-testing.\3\
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\2\ For purposes of this final guidance, the term ``financial
institution'' or ``institution'' includes national banks, federal
savings associations, and federal branches and agencies supervised
by the OCC; state member banks, bank holding companies, savings and
loan holding companies, and all other institutions for which the
Federal Reserve is the primary federal supervisor; and state
nonmember banks, foreign banks having an insured branch, state
savings associations, and all other institutions for which the FDIC
is the primary federal supervisor.
\3\ See interagency guidance ``Supervisory Guidance on Stress-
Testing for Banking Organizations With More Than $10 Billion in
Total Consolidated Assets,'' Final Supervisory Guidance, 77 FR 29458
(May 17, 2012), at http://www.gpo.gov/fdsys/pkg/FR-2012-05-17/html/2012-11989.htm, and the joint ``Statement to Clarify Supervisory
Expectations for Stress-Testing by Community Banks,'' May 14, 2012,
by the OCC at http://www.occ.gov/news-issuances/news-releases/2012/nr-ia-2012-76a.pdf; the Federal Reserve at www.federalreserve.gov/newsevents/press/bcreg/bcreg20120514b1.pdf; and the FDIC at http://www.fdic.gov/news/news/press/2012/pr12054a.pdf. See also FDIC Final
Rule, Annual Stress Test, 77 FR 62417 (Oct. 15, 2012) (to be
codified at 12 CFR part 325, subpart C).
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II. Discussion of Public Comments Received
The agencies received 16 comment letters on the proposed guidance.
Comments were submitted by bank holding companies, commercial banks,
financial trade associations, financial advisory firms, and
individuals. Generally, most comments expressed support for the
proposed guidance; however, several comments recommended changes to and
clarification of certain provisions in the proposed guidance.
The comments highlighted the following as primary issues of concern
or interest or areas that could benefit from further explanation:
The potential effect of the proposed guidance on community
and mid-sized financial institutions;
Definition of leveraged lending;
Proposed exclusions for ``fallen angels'' and asset-based
loans, and investment grade borrowers;
Reporting requirements of deal sponsors;
Proposed alternatives to the de-levering expectations;
Effect of covenant-lite and payment-in-kind (PIK)-toggle
loan structures;
Methods used to determine enterprise value;
Potential overall management information systems (MIS)
burden presented by the proposed guidance; and
Fiduciary responsibility of a financial institution for
loans that it originates.
In response to these comments, the agencies have clarified and
modified certain aspects of the guidance as discussed in the following
section of this Supplemental Information.
A. Terminology
One purpose of the final guidance is to update and replace guidance
issued in April 2001, titled ``Interagency Guidance on Leveraged
Financing'' (2001 guidance). The 2001 guidance covered broad risk
management issues associated with leveraged finance activities. This
final guidance focuses on leveraged lending activities conducted by
financial institutions. Therefore, to promote clarity and consistency,
the agencies have used the term ``leveraged lending'' in the final
guidance in place of all references to ``leveraged finance'' that
appeared in the proposed guidance. This change is intended to focus the
applicability and scope of the final guidance on specific types of
leveraged lending transactions; those leveraged loans originated by
financial institutions.
B. Scope
Several comment letters expressed concern about the potential
effect of the proposed guidance on community banks and mid-sized
institutions. The comments stressed that small financial institutions
also can have exposure to leveraged loans. All of the comments
expressed concern that the definition of leveraged lending used in the
proposed guidance would encompass a significant number of portfolio
loans originated by financial institutions, particularly small and mid-
sized banks, including, but not limited to, traditional asset-based
lending portfolios. One comment expressed concern that the guidance
could be misinterpreted to require community banks to document and bear
the burden of proof as to why certain transactions are not considered
leveraged lending. Another comment noted that community banks with an
insignificant amount of leveraged lending should not have to follow the
same risk management framework as financial institutions with
significant amounts of leveraged lending, as defined in the proposed
guidance. Some comments suggested that the proposed guidance should
exclude financial institutions under a certain asset or capital size,
or exclude transactions under a certain dollar threshold.
In response to these comments, the agencies have decided to apply
the final guidance to all financial institutions that originate or
participate in leveraged lending transactions. However, the agencies
agree with comments that a financial institution that originates a
small number of less complex leveraged loans should not be expected to
have policies and procedures commensurate with those of a larger
financial
[[Page 17768]]
institution with a more complex leveraged loan origination business.
Therefore, the final guidance addresses mainly the latter type of
leveraged lending. However, any financial institution that participates
in rather than originates leveraged lending transactions should follow
applicable supervisory guidance regarding purchased participations. To
clarify the supervisory expectations for these types of loans, the
agencies have incorporated the section on ``Participations Purchased''
from the 2001 guidance into the final guidance.
Although the agencies elected to adopt a definition of leveraged
lending that encompasses all business lines, the agencies do not intend
for this guidance to apply to small portfolio commercial and industrial
loans, or traditional asset-based lending loans. The agencies have
added language to the final guidance to clarify these concerns.
C. Definition
The agencies received five comments regarding the proposed
definition of a leveraged lending transaction. A number of comments
expressed concern over a perceived ``bright line'' approach to defining
leveraged loans and proposed that institutions should be able to set
their own definitions based on the characteristics of their portfolios.
The agencies agree that various industries have a range of acceptable
leverage levels and that financial institutions should do their own
analysis to define leveraged lending. The proposed guidance addressed
this issue by providing common definitions of leveraged lending and
directing an institution to define leveraged lending in its internal
policies. The proposed guidance also indicated that numerous
definitions of leveraged lending exist throughout the financial
services industry. However, the proposed guidance stated that
institutions' policies should include criteria to define leveraged
lending in a manner sufficiently detailed to ensure consistent
application across all business lines and that are appropriate to the
institution. Therefore, the agencies believe the definition of
leveraged lending described in the proposed guidance was appropriate,
and have retained that definition in the final guidance.
In addition, the agencies received comments on using earnings
before interest, taxes, depreciation, and amortization (EBITDA) as a
measure to define leverage. Some comments expressed concern that small
banks focus on the balance sheet measure of leverage (total debt to
tangible net worth) rather than the cash flow measure of leverage
presented in the proposed guidance definition. Other comments viewed
the ratio as a ``bright line'' and suggested that financial
institutions should develop their own definition and leverage measure
based on an institution's business lines. The agencies agree that each
financial institution should establish its metrics for defining
leveraged loans and include those indicators in its credit policies.
However, the EBITDA-based leverage measure presented in the proposed
guidance represented the supervisory measure that may be used as an
important factor to be considered in defining leveraged loans based on
each institution's credit products and characteristics. The agencies
believe that having a consistent definition for supervisory purposes
will help to ensure a consistent application of the guidance.
Accordingly, the agencies are retaining this definition from the
proposed guidance in the final guidance.
D. Information and Reporting
The agencies received a number of comments about the discussion in
portions of the proposed guidance on management information systems
(MIS) that financial institutions should implement. Comments stated it
would be burdensome for small financial institutions to implement the
same reporting mechanisms as large financial institutions. Another
comment suggested that smaller as well as mid-sized institutions should
discuss the risks with their regulators to implement appropriate
procedures.
To clarify supervisory expectations for MIS requirements, the final
guidance notes that information and reporting should be tailored to the
size and scope of each financial institution's leveraged lending
activities. The agencies would expect a global, complex financial
institution with significant origination volumes or exposures to
leveraged lending to have more complex MIS than a community bank with
only a few exposures. Moreover, the final guidance notes that each
institution should consider appropriate, cost-effective measures for
monitoring leveraged lending given the size and scope of that
institution's leveraged lending activities.
E. Additional Comments
One comment requested that the definition of leveraged lending be
modified so as not to include ``fallen angels.'' These are loans that
do not meet the definition of leverage loans at origination, but
migrate into the definition at a later date due to changes in the
borrower's financial condition. The comment suggested that the
inclusion of these loans in the definition would skew reporting and
tracking of the portfolio, duplicate monitoring activities, and
increase costs without any benefit to financial institutions or to the
regulators. The agencies agree that ``fallen angels'' should not be
included as leveraged lending transactions, but should be captured
within the financial institution's broader risk management framework.
Therefore, the agencies have stated in the final guidance that a loan
should be designated as leveraged only at the time of origination,
modification, extension, or refinance.
One comment suggested that the sponsor evaluation standards in the
proposed guidance are administratively burdensome and that financial
assessments of deal sponsors by lenders should be limited to those
sponsors that provide a financial guaranty. The agencies agree that the
ability to obtain financial reports on sponsors may be limited in the
absence of a formal guaranty. Accordingly, the final guidance removes
the statement that an institution generally should develop guidelines
for evaluating deal sponsors and instead focuses on deal sponsors that
are relied on as a secondary source of repayment. In those instances,
the final guidance notes that a financial institution should document
the sponsor's willingness and ability to support the credit.
Some comments also suggested exclusions for both asset-based loans
and ``investment-grade'' borrowers. As stated previously, the agencies
acknowledge that traditional asset-based lending is a distinct product
line and is not included in the definition of a leveraged loan unless
the loan is part of the entire debt structure of a leveraged obligor;
therefore, the agencies have clarified this point in the final
guidance. In terms of a borrower's creditworthiness, the agencies do
not believe it would be appropriate to exclude high-quality borrowers
from the guidance. Prudent portfolio management of leveraged loans,
which is a goal of this guidance, covers all loans, including those
made to the most creditworthy borrowers. Importantly, the agencies
strongly support the efforts of financial institutions to make loans
available to creditworthy borrowers, particularly in small and mid-
sized institutions that extend prudent commercial and industrial loans.
All loans and borrowers except those excluded in the final guidance
will be subject to the definitions as outlined in the guidance.
[[Page 17769]]
The agencies also received comments concerning the ability of
borrowers to repay 50 percent of the total debt exposure over a five-
to-seven year period. Some comments viewed this measure as a
restrictive ``bright line'' while others proposed alternatives.
The measure in the proposed guidance was meant as a general guide
to reflect that institutions should establish, in their policies,
expectations and measures for reducing leverage over a reasonable
period of time. The final guidance retains the expectation of
reasonable de-levering, and the agencies have revised the Underwriting
Standards section of the final guidance to state that institutions
should consider reasonable de-levering abilities of borrowers, such as
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. In addition, the agencies have revised the
Risk Rating Leveraged Loans section of the final guidance to include
the measure as an example, stating that in the context of risk rating
of leveraged loans, 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.
One comment referred to covenant-lite and PIK-toggle loan
structures, and recommended that the agencies impose tighter controls
around loans with such features. The agencies believe these types of
structures may have a place in the overall leveraged lending product
set; however, the agencies recognize the additional risk in these
structures. Accordingly, although the final guidance does not have a
different treatment for such arrangements, the agencies will closely
review such loans as part of the overall credit evaluation of an
institution.
One comment suggested that the agencies impose more conservative
guidelines for determining enterprise value. The comment recommended
that the agencies require financial institutions to use business
appraisers and to follow Internal Revenue Service (IRS) appraisal
guidelines when the institution is estimating the enterprise value of a
firm. The intent of the agencies is not to impose real property
appraisal and valuation standards to enterprise valuation methods or to
require a formal business appraisal for all loans relying on enterprise
value as a source of repayment. The goal of the final guidance is to
clarify those methods considered credible for determining enterprise
value based on common practices in the industry. These methods, if
conducted properly, produce reliable results. Accordingly, the final
guidance does not require that an evaluation be conducted by a business
appraiser in determining enterprise value. The agencies' expectation is
that a financial institution's internal policies should address the
source and method of any enterprise value estimate.
The agencies received four comments regarding the burden imposed by
the proposed guidance, stating that implementation will add to the high
costs that financial institutions already face. One comment noted there
was no cost benefit analysis provided with the proposed guidance. To
address these concerns, the final guidance emphasizes that an
institution needs to have sound risk management policies and procedures
commensurate with its origination activity in and exposures to
leveraged lending. Moreover, the final guidance notes that a financial
institution's risk management framework for leveraged lending should be
consistent with the institution's risk appetite, and complexity of
exposures. The agencies believe the implementation of any additional
systems or processes needed to promote safe-and-sound leveraged lending
should be considered a component of an institution's overall credit
risk management program.
One comment noted that financial institutions in a credit
transaction do not have fiduciary responsibilities to loan participants
when underwriting and syndicating leveraged loans. The agencies agree
and have not included a reference to fiduciary responsibility in the
final guidance.
III. Administrative Law Matters
A. Paperwork Reduction Act Analysis
In accordance with the Paperwork Reduction Act (PRA) of 1995 (44
U.S.C. 3506; 5 CFR part 1320, Appendix A.1), the agencies reviewed the
final guidance. The agencies may not conduct or sponsor, and an
organization is not required to respond to, an information collection
unless the information collection displays a currently valid Office of
Management and Budget (OMB) control number. The OCC and FDIC have
submitted this collection to OMB for review and approval under 44
U.S.C. 3506 and 5 CFR part 320. The Board reviewed the final guidance
under the authority delegated to it by OMB. While this final guidance
is not being adopted as a rule, the agencies have determined that
certain aspects of the guidance constitute collections of information
under the PRA. These aspects are the provisions that state that a
financial institution should have (i) Underwriting policies for
leveraged lending, including stress-testing procedures for leveraged
credits; (ii) risk management policies, including stress-testing
procedures for pipeline exposures; and, (iii) policies and procedures
for incorporating the results of leveraged credit and pipeline stress
tests into the firm's overall stress-testing framework. The frequency
of information collection is estimated to be annual.
Respondents are financial institutions with leveraged lending
activities as defined in the guidance.
Report Title: Guidance on Leveraged Lending.
Frequency of Response: Annual.
Affected Public: Financial institutions with leveraged lending.
OCC:
OMB Control Number: To be assigned by OMB.
Estimated number of respondents: 25.
Estimated average time per respondent: 1,350.4 hours to build;
1,705.6 hours for ongoing use.
Estimated total annual burden: 33,760 hours to build; 42,640 hours
for ongoing use.
Board:
Agency information collection number: FR 4203.
OMB Control Number: To be assigned by OMB.
Estimated number of respondents: 41.
Estimated average time per respondent: 1,064.4 hours to build;
754.4 hours for ongoing use.
Estimated total annual burden: 43,640 hours to build; 30,930 hours
for ongoing use.
FDIC:
OMB Control Number: To be assigned by OMB.
Estimated number of respondents: 9.
Estimated average time per respondent: 986.7 hours to build; 529.3
hours for ongoing use.
Estimated total annual burden: 8,880 hours to build; 4,764 hours
for ongoing use.
The estimated time per respondent is an average that varies by
agency because of differences in the composition of the financial
institutions under each agency's supervision (for example, size
distribution of institutions) and volume of leveraged lending
activities.
The agencies received two comments in response to the information
collection requirements under the PRA. Both comments mentioned how
substantially burdensome the guidance will be to implement. The
agencies recognize that the amount of time
[[Page 17770]]
required of any institution to comply with the guidance may be higher
or lower than the estimates, but believe that the numbers stated are
reasonable averages.
One comment also noted the absence of a cost-benefit analysis and
questioned whether the additional information systems required
undermines the utility of the information collection. In response to
the general comments about burden, the agencies have made various
modifications to the proposed guidance, including clarifying the
application of the guidance to community banks and other smaller
institutions that are involved in leveraged lending. In the
Supplementary Information section, the agencies also highlighted their
expectations that MIS and other reporting activities would be tailored
to the size and the scope of an institution's leveraged lending
activities. In addition, the implementation of any new systems would be
part of an institution's overall credit risk management program. These
comments are discussed in more detail in the general comment summary in
Section II of the Supplementary Information.
Comments continue to be invited on:
(a) Whether the collection of information is necessary for the
proper performance of the Federal banking agencies' functions,
including whether the information has practical utility;
(b) The accuracy of the estimates of the burden of the information
collection, including the validity of the methodology and assumptions
used;
(c) Ways to enhance the quality, utility, and clarity of the
information to be collected;
(d) Ways to minimize the burden of the information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology; and
(e) Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
Comments on these questions should be directed to:
OCC: Because paper mail in the Washington, DC area and at the OCC
is subject to delay, commenters are encouraged to submit comments by
email if possible. Comments may be sent to: Legislative and Regulatory
Activities Division, Office of the Comptroller of the Currency,
Attention: 1557-NEW, 400 7th Street SW., Suite 3E-218, Mail Stop 9W-11,
Washington, DC 20219. In addition, comments may be sent by fax to (571)
465-4326 or by electronic mail to [email protected]. You may
personally inspect and photocopy comments at the OCC, 400 7th Street
SW., Washington, DC 20219. For security reasons, the OCC requires that
visitors make an appointment to inspect comments. You may do so by
calling (202) 649-6700. Upon arrival, visitors will be required to
present valid government-issued photo identification and to submit to
security screening in order to inspect and photocopy comments.
All comments received, including attachments and other supporting
materials, are part of the public record and subject to public
disclosure. Do not enclose any information in your comment or
supporting materials that you consider confidential or inappropriate
for public disclosure.
Additionally, please send a copy of your comments by mail to: OCC
Desk Officer, 1557-NEW, U.S. Office of Management and Budget, 725 17th
Street NW., 10235, Washington, DC 20503, or by email to: oira
[email protected].
FDIC: Interested parties are invited to submit written comments.
All comments should refer to the name of the collection, ``Guidance on
Leveraged Lending.'' Comments may be submitted by any of the following
methods:
http://www.FDIC.gov/regulations/laws/federal/propose.html.
Email: [email protected].
Mail: Gary Kuiper (202) 898-3877, Federal Deposit
Insurance Corporation, 550 17th Street NW., NYA-5046, Washington, DC
20429.
Hand Delivery: Comments may be hand-delivered to the guard
station at the rear of the 550 17th Street Building (located on F
Street), on business days between 7 a.m. and 5 p.m.
As the final guidance discusses the importance of stress-testing as
part of an institution's risk management practices for leveraged
lending activity, the agencies note that they expect to review an
institution's policies and procedures for stress-testing as part of
their supervisory processes. To the extent they collect information
during an examination about a financial institution's stress-testing
results, confidential treatment may be afforded to the records under
exemption 8 of the Freedom of Information Act (FOIA), 5 U.S.C.
552(b)(8).
B. Regulatory Flexibility Act Analysis
The final guidance is not a rulemaking action. Thus, the Regulatory
Flexibility Act (5 U.S.C. 603(b)) does not apply to the guidance.
However, the agencies have considered the potential impact of the
guidance on small banking organizations. For the reasons discussed in
sections I and II of this Supplementary Information, the agencies are
issuing the guidance to emphasize the importance of properly
underwriting leveraged lending transactions and incorporating those
exposures into stress and capital tests for institutions with
significant exposures to these credits.
The agencies received comments about the potential burden of this
guidance on small banking organizations. The final guidance is intended
for banking organizations supervised by the agencies with substantial
exposures to leveraged lending activities, including national banks,
federal savings associations, state nonmember banks, state member
banks, bank holding companies, and U.S. branches and agencies of
foreign banking organizations. Given the average dollar size of
leveraged lending transactions, most of which exceed $50 million, and
the agencies' observations that leveraged loans tend to be held
primarily by very large or global financial institutions, the vast
majority of smaller institutions should not be affected by this
guidance as they have limited exposure to leveraged credits.
Interagency Guidance on Leveraged Lending
The text of the guidance is as follows:
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,
[[Page 17771]]
and the importance of stress-testing exposures and portfolios.
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\1\ OCC Bulletin 2001-18; http://www.occ.gov/news-issuances/bulletins/2001/bulletin-2001-18.html; Board SR Letter 01-9,
``Interagency Guidance on Leveraged Financing'' April 9, 2001;
http://www.federalreserve.gov/boarddocs/srletters/2001/sr0109.html;
and, FDIC Press Release PR-28-2001; http://www.fdic.gov/news/news/press/2001/pr2801.html.
\2\ For the purpose of this guidance, references to leveraged
finance, or leveraged transactions encompass the entire debt
structure of a leveraged obligor (including loans and letters of
credit, mezzanine tranches, senior and subordinated bonds) held by
both bank and non-bank investors. References to leveraged lending
and leveraged loan transactions and credit agreements refer to all
debt with the exception of bond and high-yield debt held by both
bank and non-bank investors.
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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.
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\3\ For purposes of this guidance, the term ``financial
institution'' or ``institution'' includes national banks, federal
savings associations, and federal branches and agencies supervised
by the OCC; state member banks, bank holding companies, savings and
loan holding companies, and all other institutions for which the
Federal Reserve is the primary federal supervisor; and state
nonmember banks, foreign banks having an insured branch, state
savings associations, and all other institutions for which the FDIC
is the primary federal supervisor.
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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; and,
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.\4\
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\4\ The agencies do not intend that a financial institution that
originates a small number of less complex, leveraged loans should
have policies and procedures commensurate with a larger, more
complex leveraged loan origination business. However, any financial
institution that participates in leveraged lending transactions
should follow applicable supervisory guidance provided in the
``Participations Purchased'' section of this document.
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Risk Management Framework
Given 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:
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\5\ This guidance is not meant to include asset-based loans
unless such loans are part of the entire debt structure of a
leveraged obligor. Asset-based lending is a distinct segment of the
loan market that is tightly controlled or fully monitored, secured
by specific assets, and usually governed by a borrowing formula (or
``borrowing base'').
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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
[[Page 17772]]
levels appropriate to the industry or sector.\6\
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\6\ Cash should not be netted against debt for purposes of this
calculation.
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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\
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\7\ The designation of a financing as ``leveraged lending'' is
typically made at loan origination, modification, extension, or
refinancing. ``Fallen angels'' or borrowers that have exhibited a
significant deterioration in financial performance after loan
inception and subsequently become highly leveraged would not be
included within the scope of this guidance, unless the credit is
modified, extended, or refinanced.
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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\
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\8\ Flex terms allow the arranger to change interest rate
spreads during the syndication process to adjust pricing to current
liquidity levels.
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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); and,
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 involved 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:
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\9\ Refer to other joint agency guidance regarding purchased
participations: OCC Loan Portfolio Management Handbook, http://www.occ.gov/publications/publications-by-type/comptrollers-handbook/lpm.pdf, Loan Participations, Board ``Commercial Bank Examination
Manual,'' http://www.federalreserve.gov/boarddocs/supmanual/cbem/cbem.pdf, section 2045.1, Loan Participations, the Agreements and
Participants; and FDIC Risk Management Manual of Examination
Policies, section 3.2 (Loans), http://www.fdic.gov/regulations/safety/manual/section3-2.html#otherCredit, Loan Participations,
(last updated Feb. 2, 2005).
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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;
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\10\ In general, the base case cash flow projection is the
borrower or deal sponsor's expected estimate of financial
performance using the assumptions that are deemed most likely to
occur. The financial results for the base case should be better than
those for the conservative case but worse than those for the
aggressive or upside case. A financial institution may make
adjustments to the base case financial projections, if necessary.
The most realistic financial projections should be used when
measuring a borrower's capacity to repay and de-lever.
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Expectations for the depth and breadth of due diligence on
leveraged transactions. This should include
[[Page 17773]]
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; and,
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
[[Page 17774]]
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; and,
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.\11\
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\11\ Board SR Letter 98-25 ``Sound Credit Risk Management and
the Use of Internal Credit Risk Ratings at Large Banking
Organizations;'' OCC Comptroller's Handbooks ``Rating Credit Risk''
and ``Leveraged Lending'', and FDIC Risk Management Manual of
Examination Policies, ``Loan Appraisal and Classification.''
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The 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
[[Page 17775]]
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; and,
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
[[Page 17776]]
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.
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\12\ See interagency guidance ``Supervisory Guidance on Stress-
Testing for Banking Organizations With More Than $10 Billion in
Total Consolidated Assets,'' Final Supervisory Guidance, 77 FR 29458
(May 17, 2012), at http://www.gpo.gov/fdsys/pkg/FR-2012-05-17/html/2012-11989.htm, and the joint ``Statement to Clarify Supervisory
Expectations for Stress-Testing by Community Banks,'' May 14, 2012,
by the OCC at http://www.occ.gov/news-issuances/news-releases/2012/nr-ia-2012-76a.pdf; the Board at www.federalreserve.gov/newsevents/press/bcreg/bcreg20120514b1.pdf; and the FDIC at http://www.fdic.gov/news/news/press/2012/pr12054a.pdf. See also FDIC Final
Rule, Annual Stress Test, 77 FR 62417 (Oct. 15, 2012) (to be
codified at 12 CFR part 325, subpart. C).
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Conflicts of Interest
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.
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\13\ 12 U.S.C. 1972.
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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.
Dated: February 19, 2013.
Thomas J. Curry,
Comptroller of the Currency.
Board of Governors of the Federal Reserve System, March 8, 2013.
Robert deV. Frierson,
Secretary of the Board.
Dated at Washington, DC, this 11th day of March, 2013.
Federal Deposit Insurance Corporation.
Valerie J. Best,
Assistant Executive Secretary.
[FR Doc. 2013-06567 Filed 3-21-13; 8:45 am]
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P