REGULATORS AND PARTICIPATIONS
The three primary regulators for US financial institutions – the Office of Comptroller of the Currency (OCC) for national banks, the Federal Deposit Insurance Corporation (FDIC) for community banks, and the National Credit Union Administration (NCUA) for credit unions – have recently promulgated guidance for member financial institutions regarding participation lending.
Why this apparently recent interest in loan participations, financial vehicles that have existed formally in US banking since the dawn of federal regulation of banking in the 1930s?
Despite the recent “good times” in US banking, primary regulators found it necessary to provide official guidance to member institutions to protect the safety and soundness of banks and credit unions.
The reason is simple: risk.
Let’s look at some high-level summaries of regulatory action with respect to participations. What is the history of participations? What are the risks and why are the regulators so interested in loan participations?
LET’S LOOK BACK AT PARTICIPATIONS HISTORY
Bankers that can recall the banking crises of the 1980s may recall that many experts cite loan participations in commercial real estate as a factor that exacerbated the meltdown of numerous banks and thrifts in a contagion-like fashion. The scope of the contagion shook the foundations of the US banking regulatory authority.
Many of the troubled banks were involved in networks that bought and sold participations among themselves. When loans participated among the troubled banks developed performance issues, all the banks owning participation shares were affected.
The participation “industry” at the time appeared to suffer from a lack of analysis of the various risk factors that can affect loans, especially credit risk accompanied by governance risk. Due to potential systemic risks in 1984, OCC issued a Circular “Subject: Purchase of Loans in Whole or in Part-Participations” that laid a foundation on which subsequent promulgations were based.
Inter alia, the Circular identified various participation lending components that should be addressed to maintain safe and sound lending practices for the purchase and sale of participations. These considerations included adequate credit analysis and appropriate levels of transfer of credit information regarding the loan participated. The Circular also referenced recourse agreements between buyers and sellers, a hot issue in the participation market at that time.
The Circular was rescinded by OCC’s 2020 Bulletin 2020-81 (infra)
FAST FORWARD TO THE TWENTY-FIRST CENTURY
Regulators have developed a better understanding of the effects of relationships among institutions and the potential for systemic risks to the banking system due to these relationships created by participations.
To provide guidance regarding participation risk, each of these primary regulatory bodies has promulgated guidance to member institutions regarding risks involved in participations. Financial institutions should refer to their regulator’s rules, policies, and guidelines for additional standards for the management of the participation process and associated risks.
OCC: “Credit Risk: Risk Management of Loan Purchase Activities”
This OCC Bulletin sets out a simple statement of purpose that permeates all primary regulatory guidance regarding participations: “A bank’s loan purchase activities would typically be handled in a manner consistent with its other lending activities, including sound risk management commensurate with the bank’s size, complexity, and risk profile.”
An appropriate level of participation risk management would include:
- A strategic plan
- Addressing risk limits
- Setting-out policies and procedures for participation purchases
- An analysis of credit administration
FDIC: “Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations”
This 2015 Financial Institution Letter contains a similar purpose statement regarding participations. “Institutions should underwrite and administer loan and loan participation purchases as if the loans were originated by the purchasing institution.”
Member institutions were directed to develop loan policies that address participations, to understand the Participation Agreements they enter into, to perform appropriate due diligence, and to follow appropriate governance standards by obtaining necessary levels of approval before entering into the transaction.
In separate guidance, the FDIC identified risks specifically relating to participations to include inter alia –
- Overreliance on the selling institution
- Inability to obtain timely information both in underwriting and loan administration
- Poor understanding of loss exposure when the loan underlying the participation is involved in a workout or institution liquidation
- Overreliance on recourse provisions contained in participation agreements
NCUA 2019: “The ABC’s of Loan Participation Due Diligence”
NCUA Rules Section 701.22(b)(5) provides specific requirements for applicable loan participation policies. NCUA summarized the rules regarding the contents of participation agreements. These documents shall include specific information as to the parties and amounts, portions purchased and retained, document custodial location information, and duties and responsibilities of parties to the participation agreement.
Contact BankLabs today to see how our patented end-to-end platform helps address risk and foster compliance with your participation portfolio. Email us at firstname.lastname@example.org or call 501.246.5148.