Ardmore Banking Advisors Reacts to Regulatory Guidance on Leveraged Lending

07/14/2013

 By Lou Dunham and Suzanne Storm

The regulatory agencies issued a new interagency guidance on Leveraged Lending, dated March 27, 2013 (FIL-13-2013), that updates and replaces the previous standards issued in April of 2001. The new guidance becomes effective on May 21, 2013.

The updated guidance appears to be intended primarily for larger banks that were aggressively originating structured commitments that eventually ended up on the banks balance sheets when the capital markets froze up approximately five years ago. However, the 2013 guidance applies to every FDIC-insured bank and savings association. 

The issuing regulatory agencies did state in the joint guidance, “however, the majority of community institutions should not be affected by this guidance as they have limited exposure to leveraged credits”, but if your bank does have any leveraged loans in the portfolio, it is important to be aware of the expectations the banks regulator have and should discuss appropriate controls with them.

Banks are encouraged to define leveraged lending using criteria “that are appropriate to the institution”. A typical definition of leveraged loans, which is not changed by the new guidance, is that it must meet both a purpose test and a leverage test at the time of origination, modification, extension, or refinance including:

  • Proceeds are used for buyouts, acquisitions, or capital distributions; and
  • The transaction results in cash flow leverage in excess of total debt/EBITDA over 4x, or in balance sheet leverage significantly exceeding industry norms or historical levels.

However, an additional potential qualification was added: 

  • Credit to a borrower that is “recognized in the debt markets as a highly leveraged firm” is also considered to be leveraged lending.

It is important to note that “leveraged lending” is not intended to capture asset based loans (unless they are one component of a buyout or other leveraged transaction) or ordinary C&I loans to borrowers exhibiting high leverage as a result of operations.
The guidance contains very specific policy, underwriting, and reporting and analytics requirements for leveraged lending, which apply even if the bank doesn’t underwrite any leveraged deals, but only purchases participations in them. These include:

  • A clear statement of the bank’s risk appetite for leveraged loans
  • A limit framework for leveraged deals that includes specific maximum amounts per transaction, borrower, industry, geography, and leveraged portfolio as a whole
  • Appropriate oversight by senior management and the Board
  • Independent valuations of intangibles, including enterprise value
  • Careful monitoring of the borrower’s performance throughout the life of the loan
  • Stress testing of the leveraged portfolio
  • More frequent and in-depth assessments by Loan Review 
  • Tracking and reporting portfolio performance measures

At a very minimum, to meet regulatory expectations a bank must be able to identify leveraged loans on the loan system so that they may be easily reported, aggregated and monitored by the bank. Including the definition of a leveraged transaction in loan policy and requiring elevated approval can aid in this identification process. As long as a bank can demonstrate that it is identifying and managing its exposure, the regulators have expressed their readiness to accept “cost-effective controls”, rather than the sophisticated and detailed requirements the guidance lay out for large banks.

If your bank has concerns that its policies and practices are compliant with this new guidance, Ardmore Banking Advisors would be pleased to review your existing leveraged lending policy or to craft a policy consistent with your institution’s exposure to leveraged lending.

Please contact us at (610) 649-4643 for assistance or questions.