By Heath Tarbert and Dimia Fogam

The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) released for public comment their proposed joint guidance on leveraged lending activities.

The proposed guidance is a revision to the interagency leveraged finance guidance issued in 2001 and would apply to all OCC-, FRB- and FDIC-supervised financial institutions that are substantively engaged in leveraged lending activities—such as those common to the private equity and hedge fund lending market. 

Given the immense growth in the volume of leveraged credit as well as the increased participation of non-regulated investors over the last decade, the Agencies have expressed concerns that prudent underwriting practices are deteriorating. Specifically, bank regulators have noted that debt agreements have increasingly included features that provide limited lender protection, that capital structures and repayment prospects for some transactions have at times been overly aggressive, and that management information systems at some institutions have fallen short of accurately aggregating exposures on a timely basis. 

In light of those concerns, the Agencies propose replacing their existing guidance with revised leveraged lending guidance that will form the basis of their supervisory focus and review of regulated financial institutions on a going forward basis. 

The Agencies have emphasized the importance of a supervised financial institution having the capacity to evaluate and monitor underwritten credit risk properly, ensure that each borrower has a sustainable capital structure, demonstrate an understanding of the potential impact of various forms of distress on a borrower’s financial condition, and incorporate stress testing into its risk management of both leveraged portfolios and its distribution pipeline. The proposed guidance is intended to build upon the recently proposed guidance on stress testing.

Institutions engaged in leveraged financing should adopt a risk management framework that has as its foundation written risk objectives, risk acceptance, and risk controls. The framework should have an intensive and frequent review-and-monitoring process. Among other things, the proposed guidance covers: 

  • Definition of Leveraged Finance: Institutions should define leveraged finance within their policies with sufficient detail to ensure consistent application across business lines. The definition should include the institution’s exposure to financial vehicles, whether or not leveraged, that engage in leveraged lending activities.

 

  • Policy Expectations: The leveraged finance policy should, at a minimum, identify: an institution’s risk appetite (including pipeline limits and transaction and aggregate hold levels); credit and underwriting approval authorities; expected risk-adjusted returns for leveraged transactions; and a method of ensuring that the risks of leveraged lending activities are appropriately reflected in the institution’s Allowance for Loan and Lease Losses as well as in its capital adequacy analyses.

 

  • Underwriting Standards: These should address the Agencies’ expectations for cash flow capacity, amortization, covenant protection, and collateral controls. Institutions should also devise standards for evaluating various types of collateral and expected risk-adjusted returns.  Additionally, such standards should take into account whether the business premise for a given transaction is sound and whether the borrower’s capital structure is sustainable irrespective of whether the loan is underwritten with the intent to hold or to distribute.

 

  • Valuation Standards: Given the importance of enterprise valuation in the underwriting process and the specialized knowledge needed for the development of credible enterprise valuation, it should be independently performed or validated. An institution should focus on sound methodologies in its determination of enterprise value. Furthermore, the stress testing of enterprise values and their underlying assumptions should be conducted and documented periodically

 

  • Pipeline Management:  Institutions must be able to accurately measure exposure on a timely basis and to establish policies and procedures that address failed transactions as well as general market disruptions. Each financial institution should also establish guidelines for conducting periodic stress tests on its pipeline exposures.

 

  • Reporting and Analytics:  Institutions should have information systems that accurately capture key obligor characteristics in order to aggregate them across business lines and legal entities on a timely basis. Comprehensive reports should be provided to management at least quarterly and summaries should be provided to the board of directors.

Implementation of the proposed guidance should be consistent with the size and risk profile of an institution’s leveraged portfolio relative to its assets, earning, liquidity, and capital. Although some sections of the guidance will apply to all leveraged transactions (e.g., underwriting), the vast majority of community banks should not be affected, as they have little or no exposure to leveraged loans.

Nevertheless, larger financial institutions that specialize in lending to private equity and hedge funds should expect increased supervisory scrutiny in the coming months as the proposed guidance is finalized. The deadline for submitting comments on the proposed guidance is June 8, 2012.

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The Working Group will continue to monitor any developments and provide timely coverage at Weil’s Financial Regulatory Reform Center.  If you are interested in discussing this or other regulatory developments, please contact Working Group member Heath P. Tarbert (202-682-7177 or heath.tarbert@weil.com).

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