Agencies Issue Updated Leveraged Lending Guidance

The OCC, FDIC, and Federal Reserve released an updated supervisory guidance on leveraged lending, which has been increasing since 2009 after declining during the financial crisis.

The guidance from the agencies covers transactions characterized by a borrower with a degree of financial leverage that significantly exceeds industry norms. The guidance replaces the previous guidance issued in April 2001.

This guidance applies to financial institutions supervised by the agencies that engage in leveraged lending activities. The number of community banks with substantial involvement in leveraged lending is small and they should be largely unaffected by this guidance.

Particular attention is given to the following key areas:

• Establishing a sound risk-management framework: The agencies expect management and the board of directors to identify the institution's risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes.
• Underwriting standards: An institution's underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower's capital structure is sustainable, regardless of whether the transaction is underwritten to hold or to distribute.
• Valuation standards: An institution's standards should concentrate on the importance of sound methods in the determination and periodic revalidation of enterprise value.
• Pipeline management: An institution should be able to accurately measure exposure on a timely basis, establish policies and procedures that address failed transactions and general market disruptions, and ensure periodic stress tests of exposures to loans not yet distributed to buyers.
• Reporting and analytics: An institution should ensure that management information systems accurately capture key obligor characteristics and aggregate them across business lines and legal entities on a timely basis, with periodic reporting to the institution's board of directors.
• Risk rating leveraged loans: An institution's risk rating standards should consider 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.
• Participants: An institution that participates in leveraged loans should establish underwriting and monitoring standards similar to loans underwritten internally.
• Stress testing: An institution should perform stress testing on leveraged loans held in portfolio, as well as those planned for distribution, in accordance with existing interagency issuances.

See also: FDIC Press Release, OCC Press Release, FRB Press Release.