The FDIC has issued guidance to all FDIC-supervised banks and savings associations on effective credit risk management practices for purchased loan participations. The guidance, published on September 12 in FDIC Financial Institution Letter No. FIL-38-2012, warns that over-reliance on lead institutions by purchasing banks in loan participations has, in some instances, caused significant credit losses and contributed to bank failures, particularly for loans to out-of-territory borrowers and obligors involved in industries unfamiliar to the purchasing bank. The guidance recommends that banks apply the same underwriting and loan administration practices to loan participations as if the purchaser were directly originating the loan. According to the guidance, banks should implement an appropriate credit risk management framework before purchasing a participation loan. The credit risk management framework should include effective loan policy guidelines, written loan participation agreements, independent credit analysis and review procedures, and a comprehensive due diligence process. The guidance reiterates the FDIC’s support of banks’ efforts to meet the credit needs of their communities in part through loan participations and the FDIC’s expectations that institutions exercise sound judgment and strong underwriting when purchasing loan participations.

Nutter Notes: The guidance recommends that loan policies outline procedures for originating and purchasing participation loans, require thorough borrower due diligence at origination and over the life of the participation, and mandate an assessment of the purchasing bank’s contractual rights and obligations. The guidance also recommends that banks consider including commitment limits for aggregate purchased participations, out-of-territory participations, and loans originated by individual lead institutions. Written loan participation agreements should fully describe the lead institution’s responsibilities, establish requirements for obtaining timely borrower credit information, address remedies upon default, and outline dispute resolution procedures, according to the guidance. In terms of credit and collateral analysis, the guidance urges banks to perform the same degree of independent analysis as if they were the originator. Finally, the guidance recommends that banks perform extensive due diligence of participations involving an out-of-territory loan or credit facility to a borrower in an unfamiliar industry, including review and monitoring of the obligor, source of repayment, market conditions, and potential vulnerabilities.