Prompted by concerns about increasing leveraged lending volumes since 2009 and deterioration of prudent underwriting practices, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (the Board) and the Federal Deposit Insurance Corporation (FDIC) (collectively, the Agencies) have jointly issued updated supervisory guidance for financial institutions engaged in leveraged lending activities (the Final Guidance).1 According to the Agencies, the guidance covers “transactions characterized by a borrower with a degree of financial leverage that significantly exceeds industry norms.”2 The Final Guidance, which updates and supersedes guidance issued by the Agencies in 2001 (the 2001 Guidance),3 is similar to and in some ways less restrictive than the initial proposal released by the Agencies last year (the Proposed Guidance).4
The Final Guidance does not constitute a formal rulemaking by the Agencies, but instead has been issued as formal guidance that is “designed to assist financial institutions in providing leveraged lending to creditworthy borrowers in a safe-and-sound manner.”5 It outlines high-level principles for safe-and-sound leveraged lending activities and describes the Agencies’ “minimum expectations” for a financial institution’s overall risk management framework for its leveraged lending activities, focusing on a number of key areas outlined below. Even though the Final Guidance is not a formal rule, it will form the basis of the Agencies’ supervisory focus and review of the leveraged lending activities of supervised financial institutions. According to the Agencies, a financial institution that lacks sufficiently robust risk management processes and controls for its leveraged lending activities in accordance with the Final Guidance may be found to be engaging in unsafe-and-unsound banking practices, which could subject a financial institution to a wide range of potential informal or formal enforcement measures.
In general, the Final Guidance does not represent a fundamental deviation from the Agencies’ prior approach to leveraged lending. The Agencies state that the guidance is intended to be consistent with “sound industry practices,” and it generally appears to describe risk management practices which many large financial institutions engaged in substantial leveraged lending activities already follow. However, the Final Guidance does reflect a heightened focus by the Agencies on appropriate risk management policies, procedures and practices. Whereas the 2001 Guidance set forth very general standards, the Final Guidance provides significant additional detail in a number of areas and contains a number of specific, bright-line tests by which various aspects of an institution’s leveraged lending activities should be measured. Additionally, the Final Guidance’s enhanced detail in a number of key areas presents institutions with potentially significant implementation challenges, including undertaking modifications and enhancements to policies, procedures, controls, monitoring, reporting and management information systems.
The Final Guidance became effective when it was published, and the compliance date for the Final Guidance is May 21, 2013.6
Who Is Covered by the Final Guidance?
Generally, the Final Guidance applies to all “financial institutions” supervised by the Agencies that engage in leveraged lending activities (defined below), either as originators or as participants. Financial institutions covered by the Final Guidance include national banks, federal savings associations, state nonmember banks, state member banks, bank holding companies and US branches and agencies of foreign banking organizations.
The guidance is intended primarily for financial institutions with substantial exposures to leveraged lending activities. However, community banks and smaller institutions that are involved in leveraged lending activities are also covered by the guidance. Community banks and smaller institutions are expected to implement policies, procedures and controls that are appropriate for the complexity of their leveraged lending exposures and activities.
Subsidiaries and affiliates of financial institutions involved in leveraged lending activities are also covered by the Final Guidance.
What Activities Are Covered by the Final Guidance?
While much of the Final Guidance focuses on leveraged loans originated by financial institutions (whether underwritten for an institution’s own portfolio or with the intent to distribute), it is intended to cover all types of leveraged debt except for bonds (including high-yield bonds). Participations in and assignments of leveraged loans acquired by financial institutions are also covered by the guidance. Although traditional asset-based loans (ABL) are generally excluded from the coverage of the Final Guidance, any ABL that is part of a leveraged borrower’s overall debt structure is subject to the guidance.
Certain aspects of the Final Guidance will also apply to a financial institution’s indirect exposures to leveraged lending transactions, such as limited recourse financings secured by leveraged loans or financing provided to financial intermediaries (i.e., conduits and special purpose entities that make or invest in leveraged loans). For example, warehouse lending for collateralized loan obligation (CLO) transactions would appear to be covered by the guidance if the CLO portfolio contains leveraged lending assets. The Final Guidance does not address whether it is intended to apply to leveraged loans held in an institution’s trading portfolio or not
The Definition of Leveraged Lending
On the issue of defining leveraged lending, the Final Guidance generally continues the approach taken in the 2001 Guidance by reinforcing the need for each financial institution to adopt its own appropriate definition of leveraged lending. A financial institution’s definition must be based on the characteristics of the institution’s loan portfolio and must be sufficiently detailed to ensure consistent application across all of its business lines. The Agencies emphasize that the definition also must be “thorough”, that is, it must address risk from both direct exposure and indirect exposure (such as those described above). Unlike the 2001 Guidance, however, which merely set out the general standard, i.e., that institutions should have a definition of leveraged lending in their internal loan policies, the Final Guidance provides guidance as to the factors that institutions should consider in defining leveraged lending. More specifically, the Agencies note that there are a number of definitions for leveraged lending used within the financial services industry that typically contain some combination of the following four enumerated factors:
- loans where the proceeds are used for buyouts, acquisitions or capital distributions;
- transactions where a borrower’s total debt-to-EBITDA ratio exceeds 4:1, its senior debt-to-EBITDA ratio exceeds 3:1, or these measures exceed other defined levels appropriate for the relevant industry or sector;
- loans to a borrower recognized in the debt markets to be highly leveraged based on a debt-to-net worth ratio; and
- transactions that leave a borrower with higher-than average leverage (as measured by debt-to-assets, debt-to-net-worth, debt-to-cash flow or other similar ratios) as compared to industry norms or historic levels.
Reflecting an important clarification based on industry comments to the Proposed Guidance, the Agencies have confirmed in the Final Guidance that the determination of whether a loan should be designated as leveraged should only be made at the time of origination, modification, extension or refinancing. Accordingly, loans to so-called “fallen angels”—loans that did not fall within the definition of leveraged lending at origination but subsequently migrated into the definition as a result of changes in the borrower’s financial condition—are not subject to the Final Guidance. However, such loans should nonetheless be covered by the financial institution’s overall risk management framework.
Expectations Under the Final Guidance
The Final Guidance sets “minimum expectations” for financial institutions in a number of specific areas related to leveraged lending activities. It is intended to serve both as the basis for updated financial institution policies and procedures, and as the regulatory road map for the relevant Agency’s supervision, review and evaluation of a financial institution’s conduct of its leveraged lending business. The Agencies advised financial institutions to expect significantly increased scrutiny of leveraged transactions in accordance with the framework set forth in the Final Guidance.
Risk Management Framework
The primary focus of the Final Guidance is in ensuring that financial institutions that engage in leveraged lending have a sufficiently robust and written risk management framework with clearly articulated risk objectives, risk acceptance criteria, and risk controls that are subject to intensive and frequent review and monitoring. The Final Guidance expressly provides that the absence of an appropriate risk-monitoring framework or deficiencies in its controls could lead to an unfavorable supervisory finding that the financial institution is engaged in “unsafe-and-unsound banking practices.” Such a finding would have considerable and potentially onerous consequences for a financial institution, including reputational damage and a wide range of possible informal and formal enforcement measures available to the Agencies such as cease-and-desist orders and the imposition of civil money penalties.
General Risk Policies
In contrast to the 2001 Guidance, which merely provided a general outline of the requirements of a financial institution’s policies and procedures for leveraged lending, the Final Guidance sets out in detail a number of topics that should be addressed in an institution’s leveraged lending policies and procedures. An institution should have policies and procedures that address, among other things: (i) institutional risk appetite (supported by appropriate analysis and approved by its board of directors); (ii) a limit framework that incorporates limits based on a range of both borrower-related and internal factors identified in the Final Guidance; (iii) a process for appropriately reflecting leveraged lending risks in the institution’s allowance for loan and lease losses (ALLL) and capital adequacy analyses; (iv) minimum underwriting standards (as discussed further below) and effective underwriting practices; (v) expected risk-adjusted returns; and (vi) internal approval, oversight and reporting processes.
In general, financial institutions with significant leveraged lending activities are expected to have complex policies and procedures that will provide a more nuanced view of potential risk.
Effectively restating the 2001 Guidance on purchasing participations and assignments, the Final Guidance indicates that financial institutions should apply the same standards to a participation or assignment that would be employed if the institution were originating the loan. At a minimum, policies for the acquisition of participations and assignments should include requirements to:
- obtain and analyze full credit information before the purchase and on a timely basis thereafter;
- obtain from the lead lender and independently review all loan and supporting documents, including security documents and legal opinions;
- monitor the borrower’s performance through the life of the loan; and
- establish appropriate risk management guidelines as set forth in the Final Guidance.
Financial institutions should have underwriting standards that are “clear, written and measurable” and that reflect a financial institution’s leveraged lending risk appetite, including defined underwriting limits on an individual and aggregate basis. Unlike the 2001 Guidance, the Final Guidance also contains a caution from the Agencies about the need to consider reputational risks resulting from poorly underwritten transactions. Under the Final Guidance, an institution’s underwriting policies should, at a minimum, address such things as:
- confirmation of a sound business premise for each transaction (including deals intended to be held in the institution’s portfolio and those intended for distribution ) and a sustainable capital structure for each leveraged borrower;
- borrower’s ability to fully amortize senior secured debt or repay a “significant” portion of total debt over the medium term (based on cash-flow projections that include realistic downside scenarios);
- expectations for the breadth and depth of due diligence, including standards for evaluating collateral;
- standards for evaluating risk-adjusted returns, including identification of expected distribution strategies during normal circumstances and during market disruptions;
- the degree of reliance on enterprise value and other intangible assets for loan repayment;
- expectations for the degree of sponsor support (if any) and guidelines for evaluating and documenting such support;
- whether the credit agreement covenants require lender approval for the material dilution, sale or exchange of collateral;
- credit agreement covenant protections that include financial performance, reporting requirements, and compliance monitoring; and
- whether credit agreement contain provisions covering collateral standards, valuation and controls.
These expectations should be integrated into the processes by which financial institutions conduct due diligence, prepare loan documentation and secure leveraged loans. These underwriting standards need to be understood not only by credit committees and risk management personnel, but also by client-facing personnel, internal lawyers, and outside counsel.
Given the emphasis in the Final Guidance on the borrower’s ability to repay the debt and to de-lever to a sustainable capital structure, enterprise valuation is considered by the Agencies to be a secondary aspect of an underwriting decision in a leveraged lending transaction. However, the Final Guidance does acknowledge that enterprise value may be considered by lenders for a number of purposes and emphasizes the importance of having these valuations performed independently from the origination function. Although the Final Guidance mentions assets valuation, income valuation, and market valuation as commonly used and acceptable valuation methods, it expressly notes that the income method is often considered the most reliable and provides guidance concerning two common approaches utilized in the income method. Valuations should be based on whichever methods provide “supportable and credible” results. The Final Guidance also notes that enterprise values should be subject to stress testing under a range of stress scenarios, both at origination and periodically thereafter.
The Final Guidance also sets forth expectations for certain policies and limits for financial institutions that rely on enterprise valuation, or illiquid or hard-to-value collateral.
The robust management and oversight of the transactions “in the pipeline” is another area of enhanced focus in the Final Guidance, with the regulatory intent of minimizing a financial institution’s inability to move transactions through the pipeline in case of market disruptions. The Final Guidance states that financial institutions should track closely the status and health of the commitment pipeline, and develop the ability to differentiate transactions according to tenor, investor class, structure and key borrower characteristics.
The Final Guidance provides that a financial institution should have pipeline management policies that address, among other things: (i) underwriting risk appetite; (ii) a limit framework (including limits on aggregate pipeline commitments and borrower, counterparty and aggregate hold levels); (iii) periodic stress testing on pipeline exposures; (iv) defining and managing distribution failure and “hung” deals (i.e., unable to sell down an exposure within 90 days from closing); (v) controls to monitor pipeline performance; (vi) contingent liquidity and compliance with the Board’s Regulation W (relating to restrictions on transactions with affiliates) during disruptions of normal distribution channels for loans underwritten for distribution; and (vii) regular reporting to management of variances and individual and aggregate transaction information regarding risks and concentrations in the institution’s pipeline.
Reporting and Analytics
In order for a financial institution to monitor and manage the risks associated with its leveraged lending activities, the institution’s management must have a clear understanding of the institution’s leveraged lending exposures on a regular and timely basis. This section in the Final Guidance is completely new from the 2001 Guidance and may represent the area with the immediate practical impact on the institutions subject to the Final Guidance. The Final Guidance includes significant detail about the level and type of monitoring and reporting that should accompany institutional oversight of leveraged lending activities. The Agencies emphasize the need for financial institutions to have management information systems (MIS) that capture accurate and timely information, on a comprehensive basis, about characteristics and trends in their leveraged lending portfolios. The Final Guidance sets out more than a dozen detailed regulatory expectations as to the nature, type and quality of information that should be captured and reported to a financial institution’s senior management at least quarterly, with summaries provided to the board of directors.
Some of the information fields and analytical components that a financial institution’s MIS are expected to address under the Final Guidance include: (i) individual and portfolio exposures, within and across all business lines and legal vehicles, including the pipeline; (ii) risk rating distribution and migration analysis; (iii) industry mix and profile; (iv) amount of impaired assets and the nature of impairment; (v) probabilities of default and loss given default; (vi) portfolio performance measures, including noncompliance with covenants, restructurings, delinquencies, non-performing amounts as well as charge-offs; (vii) the amount of ALLL attributable to leveraged lending; (viii) total and segmented leveraged lending exposures, exposures by collateral typ, and exposures by deal sponsors; and (ix) actual versus projected distribution of the syndicated pipeline.
Institutions are also expected to collect and report information on global exposures and exposures booked in other business units, including any indirect exposures to an obligor, such as through referenced assets underlying swaps and repo transactions, and positions held through structured investment vehicles owned or sponsored by the originating institution or affiliated entities.
Building on previously issued guidance on rating credit exposures that is applicable to all credit transactions,7 the Final Guidance provides greater detail about the Agencies’ expectations as to the risk rating of a leveraged loan. The “risk rating” is the process of making realistic repayment assumptions to determine a borrower’s ability to de-lever to a sustainable level within a reasonable period. As an example, the Agencies note that banking supervisors commonly assume that the ability to fully amortize senior secured debt or the ability to repay at least 50 percent of total debt over a five to seven year period provides evidence of adequate repayment capacity. Institutions are advised to ensure that extensions and restructurings are not being used to mask repayment capacity problems. The Agencies clearly suggest that a loan should receive an “adverse rating” if the assumptions indicate a lender’s nominal ability to de-lever with refinancing as the only option, and a loan should receive a substandard rating if the projections indicate that a borrower has no reasonable or realistic prospects to de-lever.
The Agencies have retained their position from the 2001 Guidance in stating that it is generally inappropriate to consider enterprise value as a secondary source of repayment. However, exceptions can be made where enterprise value is “well-supported,” as outlined in the guidance.
Expanding on the standards in the 2001 Guidance, the Final Guidance notes that effective underwriting and management of risks from leveraged lending requires a comprehensive assessment of financial, business, industry, and management risks, both during the loan approval process and on an ongoing basis. The Agencies expect that a financial institution’s policies should address a number of factors related to such risks, including, among other things, whether:
- the cash flow analysis is based on realistic projections;
- the liquidity analysis is appropriate based on a number of borrower-related factors;
- projections account for certain potential costs and are stress tested;
- transactions are reviewed at least quarterly to determine and document, among other things, variance from plan, related risk implications, and accuracy of risk ratings;
- enterprise and collateral valuations are timely and independently derived and validated;
- collateral liquidation and asset sale estimates are realistic, and potential collateral shortfalls are identified and factored into risk rating and accrual decisions; and
- contingency plans consider changing market conditions if repayment relies on refinancing or the issuance of new equity.
Problem Credit Management
The Agencies emphasize the need for financial institutions to have individual action plans for borrowers experiencing difficulties, and to have credit policies regarding the management of adversely rated and high-risk borrowers. The Final Guidance advocates that these action plans should contain quantifiable objectives and measureable time-frames and should provide for regular review of problem credits. Action plans should provide for working with the borrower for an orderly resolution while preserving the institution’s interests.
The Agencies have recommended that where a financial institution relies on sponsor support as a secondary source of repayment, such financial institution should develop guidelines to evaluate a sponsor’s qualifications and regularly monitor a sponsor’s financial condition. Consistent with the 2001 Guidance, the Final Guidance provides that support from a sponsor may be considered as long as the institution can adequately document the sponsor’s history of demonstrated support as well as its economic incentive, capacity, and stated intent to continue to support the transaction. Unlike the 2001 Guidance, the Final Guidance suggests a number of elements that a financial institution should include in its evaluation of a sponsor’s financial support. The Agencies have suggested that this evaluation alone may not be enough to mitigate any supervisory concerns—a separate, documented commitment of continued support of the transaction by the sponsor may also be required.
The Final Guidance expects a financial institution to have a strong and independent credit review function that, at least annually (or more frequently, based on certain risk characteristics), assesses, in depth, the performance of the leveraged loan portfolio. The Agencies expect that any credit review is performed by individuals with requisite expertise and experience, and that the following criteria should be evaluated: (i) level of risk in the leveraged loan portfolio; (ii) integrity of the risk-rating; (iii) valuation methodology adopted; and (iv) quality of the overall risk management. Such credit review function should demonstrate the ability to identify portfolio risks and should also have documented authority to escalate inappropriate risks and other findings to senior management.
Expanding on recent interagency guidance on stress-testing, the Final Guidance provides that a financial institution should develop and implement a program for periodic stress-testing of its loan portfolio, in a manner that is consistent with the leveraged loan portfolio’s size, complexity and other unique characteristics. As noted above, the requirement for stress-testing forms part of a financial institution’s pipeline management, as well as part of a financial institution’s underwriting standards.
Other Areas Covered
In addition to the areas discussed above, the Final Guidance also addresses the Agencies’ expectations regarding the reputational risk associated with leveraged lending transactions and certain compliance issues associated with leveraged transaction (such as compliance with anti-tying regulations and securities laws). The Agencies also emphasize the need for financial institutions to be vigilant in identifying and managing conflicts of interest arising because of the numerous relationships that a financial institution and its affiliates may have with a single borrower, and the impact, subjective or objective, each of these relationships could have on different parts of the business.
Impact of the Final Guidance
Although in substance the Final Guidance does not represent a significant departure from the Agencies’ overall approach to leveraged lending in the 2001 Guidance, the Final Guidance will likely have important consequences for financial institutions that are engaged in leveraged lending. Perhaps the most immediate impact on financial institutions will be related to the implementation of changes to policies, procedures, MIS, and reporting systems in order to satisfy the Agencies’ expectations. As noted above, the Final Guidance provides significant additional detail in these areas, which will require financial institutions to review and update their policies, procedures and processes in a wide range of areas (including due diligence, credit approval, underwriting, stress testing, and reporting) relating to both originated and participated leveraged lending transactions in order to address issues raised by the Agencies. The Final Guidance also explicitly addresses pipeline risk and indirect exposures through structured products and vehicles, potentially significantly expanding the scope of what financial institutions must consider in evaluating their leveraged portfolios.
Institutions will be expected to have in place systems (including MIS) to demonstrate the ability to collect certain information and conduct appropriate risk analysis for leveraged lending transactions, to analyze and monitor risks on a lifecycle basis for each transaction as well as on an institutional and portfolio basis. Accordingly, the Final Guidance presents significant implementation challenges to affected institutions. While many institutions have already commenced preparations for implementing the Final Guidance based on the Proposed Guidance last year, completing the implementation will likely require considerable additional effort by affected institutions.
In the Final Guidance, the Agencies noted the emergence of covenant-lite and PIK-toggle structures in leveraged lending transactions since the issuance of the 2001 Guidance, observing that such structures serve to lessen lenders’ recourse options. In response to a public comment to the Proposed Guidance, the Agencies declined to impose tighter controls around loans with such features or to provide for a different treatment for such arrangements in the Final Guidance. However, while acknowledging that these types of structures may have a place in the “overall leveraged lending product set,” the Agencies noted the additional risk associated with such structures and emphasized that such loans will be subject to closer review as part of the relevant Agency’s overall credit evaluation of an institution.
The broader potential impact of the Final Guidance remains unclear at this point. For one thing, there are a number of interpretive issues that remain unresolved by the guidance, such as the extent to which the guidance applies to affected financial institutions’ trading portfolios or other secondary market transactions involving leveraged loans. Also, some commenters to the Proposed Guidance last year expressed concerns that the additional costs and compliance burdens associated with the guidance could lessen the desire and/or ability of financial institutions to underwrite and syndicate leveraged transactions, thereby potentially reducing the availability and increasing the cost of credit in the marketplace generally. Commenters also raised the possibility for some leveraged lending to migrate to unregulated or less regulated lenders. Whether the Final Guidance will have such impacts on the market remains to be seen and will largely depend on how the guidance is implemented by the Agencies over the coming months and beyond.