On November 6th, the FDIC issued an advisory letter discussing risk management practices that FDIC-supervised banks should implement with regards to purchased loans and loan participations. While the FDIC acknowledges the benefits accruing from the purchase of these loans and loan participations, such as achieving growth goals, diversifying credit risk, and deploying excess liquidity, the FDIC also recognizes that purchasing banks have oftentimes relied too heavily on lead institutions when administering these types of loans. In such a case, over-reliance on the lead banks has resulted in significant credit losses and failures of the purchasing institutions. Thus, while the FDIC reiterates its support for these types of investments, the FDIC also reminds banks to exercise sound judgment in administering purchased loans and participations.
A summary of the key takeaways from the FDIC’s advisory letter follows below:
- Banks should create and utilize detailed loan policies for purchased loans and loan participations. The loan policy should address various topics, including but not limited to: defining loan types that are acceptable for purchase; requiring independent analysis of credit and collateral; and establishing credit underwriting and administration requirements unique to these types of purchased loans.
- Banks should perform the same level of independent credit and collateral analysis for purchased loans and participations as if they were the originating bank. This assessment should be conducted by the purchasing bank and should not be contracted out to a third party.
- The agreement governing the loan or participation purchase should fully set out the roles and responsibilities of all parties to the agreement and should address several topics, including the requirements for obtaining timely reports and information, the remedies available upon default and bankruptcy, voting rights, dispute resolution procedures, and what, if any, limitations are placed on the purchasing bank.
- Banks should exercise caution and conduct extensive due diligence when purchasing participations involving out-of-territory loans or borrowers in an unfamiliar industry. Banks should also exercise due diligence, including a financial analysis, prior to entering into a third-party relationship, to determine whether the third party has the capacity to meet its obligations to the purchasing bank.
- Finally, banks should not forget to include purchased loans and loan participations in their audit and loan review programs and to obtain approval from the board before entering into any material third-party arrangements.