Last Thursday, May 21, the federal banking regulators issued their final guidance on leveraged lending. The new guidance covers underwriting, assessing and documenting enterprise value of borrowers, risk management, expectations for stress testing, and portfolio management for the pipeline. While the new guidance was effective last Friday, the compliance date is May 21, 2013.

The guidance is applicable to leveraged loans originated by all banks, savings associations, U. S. branches and agencies of foreign banks, bank holding companies, savings and loan holding companies, and their subsidiaries and affiliates. Although the agencies received several comment letters expressing concern that the proposed guidance would cover many portfolio loans originated by community banks, including traditional asset-based lending and cover community banks with an insignificant amount of leveraged lending, the agencies decided not to exempt small banks or small loans. However, they expressed an intent not to apply the guidance to small portfolio commercial and industrial loans or traditional asset-based lending. The guidance provides that implementation should be consistent with the size and risk profile of the bank's leveraged activities. Small banks involved in leveraged lending are to discuss cost-effective implementation with their regulators.

While some urged the agencies to adopt a "bright-line" definition of "leveraged lending," the guidance leaves it up to each bank to define "leveraged lending" using criteria that are appropriate to the lender. However, a lender's definition of "leveraged lending" is to be sufficiently detailed to ensure consistent application across business lines. While some also disfavored using EBITDA to define leverage, preferring a balance sheet measure of leverage, the final guidance notes that numerous definitions of "leveraged lending" include the ratio of a borrower's total debt to EBITDA exceeding 4 and the ratio of a borrower's senior debt to EBITDA exceeding 3. Other common elements of a definition cited by the guidance include use of proceeds for buyouts, acquisitions, or capital distributions; recognition in the debt markets that a borrower is highly leveraged, characterized by a high debt to net worth ratio; and transactions in which the borrower's leverage ratio significantly exceeds industry norms or historical levels. "Leveraged lending" is determined at origination, modification, extension, and refinancing; "fallen angels" (borrowers whose financial performance has deteriorated after loan origination and who subsequently become highly leveraged) are not in scope unless the credit is modified, extended, or refinanced.

MIS requirements may be tailored to the size and scope of a lender's leveraged lending activities.

A lender's leveraged lending policies and procedures should identify its risk appetite for leveraged lending, and that needs to be supported by an analysis of its effect on earnings, capital, and liquidity. The determination of risk appetite is to be approved by the lender's board of directors.