The OCC outlines safety and soundness principles and appropriate risk management processes for its regulated institutions that engage in venture lending.
On November 1, 2023, the Office of the Comptroller of the Currency (OCC) issued Bulletin 2023-34 (the Guidance), which clarifies the OCC’s policy positions regarding the risk management of venture loans. These lending activities involve commercial loans made to companies that do not primarily rely on their own internally generated cash flow to maintain and grow operations, but rather on equity infusions.
As a general matter, the OCC states that a bank’s venture lending practices should be appropriate to the bank’s size and complexity, and consistent with the bank’s risk appetite and policies and procedures (as established and communicated by the bank’s board of directors and senior management). The OCC expects banks involved in this type of lending activity to identify, measure, monitor, and implement adequate controls over the bank’s risks, while maintaining sufficient capital buffers.
The Guidance applies to all OCC-regulated institutions, including national banks, federal savings associations, covered savings associations, and federal branches and agencies of foreign banking organizations. The OCC also highlighted that the Guidance applies to community banks engaging in (or considering engaging in) venture lending.
The Risks of Venture Companies and Loans
The OCC considers venture companies to be higher risk in comparison to borrowers that can rely on internally generated cash flow to support operations. In its view, early- and expansion-stage companies often have untested business models, undeveloped or unproven products or services, limited or no revenue, high expenses, and limited operating histories for lenders to evaluate and underwrite. Late-stage venture borrowers may be more established, but still face risks such as negative, intermittent, or insufficient cash flow, and resultant difficulty in servicing debt. Because internally generated cash flow may be insufficient at all stages of development, venture borrowers often rely on external equity financing to support continued operations.
The OCC also identifies other risks associated with venture companies, including:
- incomplete management teams or business infrastructures;
- declining or insufficient liquid assets and working capital;
- insufficient assets to pledge as collateral to mitigate high credit risk;
- reliance on uncommitted equity funding to provide for the primary source of repayment or to continue operating as a going concern; and
- ongoing uncertainty about the borrower’s long-term viability.
The OCC generally discourages commercial lenders from engaging in venture loans that lack a satisfactory primary source of repayment (such as reliable operating cash flows), considering them to be inconsistent with safe and sound lending standards. It states: “Venture loans originated with a non-pass risk rating are inconsistent with safe and sound lending standards. Banks’ venture lending standards should deter the origination of loans rated non-pass at inception, unless the origination is part of a risk mitigation strategy in which the origination intends to improve an existing non-pass loan.”
Venture Lending Risk Management
Because of the various risks identified above, venture lending requires robust credit underwriting analysis and monitoring for materially adverse exposures. The OCC expects that banks engaged in venture lending “establish appropriate operational and managerial standards consistent with the safe and sound practices” as defined in the Interagency Guidelines Establishing Standards for Safety and Soundness.
Banks should establish and maintain prudent risk-rating and credit underwriting practices, including considering the borrower’s overall financial condition and repayment capacity.
Other operational and managerial practices that the OCC considers appropriate for venture lending include:
- a clear risk appetite statement and risk limits for venture lending approved by the board of directors, and aligned with the bank’s size and complexity;
- qualified staff with relevant experience lending to startup or high-growth companies;
- internal reporting and management information systems to help identify, measure, monitor, and control venture lending risks;
- systems to identify problem assets and corrective actions to prevent further deterioration;
- stress testing of the venture portfolio to determine adequacy of the bank’s capital and liquidity to withstand adverse conditions; and
- timely and accurate risk-rating processes and appropriate credit risk review processes to identify problem assets.
Banks should also understand the effects that shifting market conditions may have on a venture borrower’s capacity “to execute its business plan, raise additional private or public capital, maintain its equity valuation, or exit via merger or acquisition.”
In the Guidance, the OCC maintains its conservative approach to venture lending. OCC-regulated institutions should be aware, moreover, that increased exposure to venture lending may lead to higher risk management expectations and heightened regulatory scrutiny. According to the OCC, “[i]t remains the responsibility of the bank’s board and management to demonstrate to examiners that the bank’s activities are consistent with the bank’s risk appetite, maintained within established risk limits, appropriately documented and underwritten, accurately risk-rated, and sufficiently reserved.” In the wake of the March 2023 bank failures, the degree to which the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation follow the OCC’s approach with respect to the state-chartered banks for which they are the primary federal supervisors bears watching.