The federal banking agencies have issued updated supervisory guidance on leveraged lending, titled Interagency Guidance on Leveraged Lending, which applies to all financial institutions, including small and mid-sized banks, which originate or participate in leveraged lending transactions. The guidance issued on March 21 updates and replaces guidance issued in April 2001, titled Interagency Guidance on Leveraged Financing. The new guidance focuses on establishing a sound risk-management framework, underwriting standards, valuation standards, pipeline management, reporting and analytics, risk rating leveraged loans, the risks of participants (versus originators) and stress testing. According to the guidance, the agencies expect that an institution’s management and board of directors will identify the institution’s risk appetite for leveraged lending, establish appropriate credit limits and ensure prudent oversight and approval processes. The guidance recommends that an institution’s valuation standards should concentrate on sound methods in the determination and periodic revalidation of the borrower’s enterprise value. The agencies said that they expect institutions to be able to accurately measure exposures to loans on a timely basis, establish policies and procedures that address failed transactions and general market disruptions, and ensure periodic stress tests of exposures. The guidance became effective on March 22, and institutions engaged in leveraged lending activities must be in compliance with the guidance by May 21.

Nutter Notes: The guidance does not include a bright line test to determine which financing activities constitute leveraged lending. Instead, the guidance advises each institution engaged in leveraged lending to develop criteria to define leveraged lending within the institution’s policies and procedures in a manner sufficiently detailed to ensure consistent application across all business lines. The guidance gives examples of the types of criteria institutions should consider, such as transactions where loan proceeds are used for buyouts, acquisitions, or capital distributions, and transactions in which the borrower’s post-financing leverage significantly exceeds industry norms or historical levels. As a result, the guidance could apply to some commercial portfolio loans originated by small and mid-sized banks, including, but not limited to, certain asset-based loans. The agencies explained in the preamble to the guidance that an institution that originates a small number of less complex leveraged loans should not be expected to have policies and procedures commensurate with those of a larger institution with a more complex leveraged loan origination business. Although the concept of leveraged lending encompasses all business lines, the agencies said that they do not intend for the guidance to apply to small portfolio commercial and industrial loans, or traditional asset-based lending.