[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.
---------------------------------------------------------------------------

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:
---------------------------------------------------------------------------

    \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'').
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \6\ Cash should not be netted against debt for purposes of this 
calculation.
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \8\ Flex terms allow the arranger to change interest rate 
spreads during the syndication process to adjust pricing to current 
liquidity levels.
---------------------------------------------------------------------------

     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:
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

     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;
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \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.''
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

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