Why it matters

In a new advisory, the Federal Deposit Insurance Corporation (FDIC) provided a reminder to all covered entities of the importance of underwriting and administering purchased loans and loan participations as if the loans were originated by the purchasing institution. Financial institutions must understand the loan type, the obligor's market and industry, and the credit models relied upon to make credit decisions, FIL-49-2015 explained, and cannot contract out to a third party the assessment and determination of whether the loans or participations purchased are consistent with the institution's risk appetite and comply with its loan policy guidelines. The guidance updates an earlier advisory from the FDIC and emphasizes that any third-party arrangements to facilitate the purchase process must be managed by an effective third-party risk management process. We believe the imposition of these new requirements may deter banks—particularly smaller institutions—from purchasing loans from online marketplace lenders and others, given the cost of due diligence expected by the FDIC.

Detailed discussion

Having noticed that some banks are overrelying on lead institutions to purchase loans and neglecting to analyze the potential risks arising from the arrangement, the Federal Deposit Insurance Corporation (FDIC) released a new advisory to remind financial institutions to treat purchased loans like originated loans.

FIL-49-2015 set forth effective risk management practices for purchased loans and purchased loan participations, replacing an earlier advisory, FIL-38-2012 on Effective Credit Risk Management Practices for Purchased Loan Participations.

"[A]n increasing number of financial institutions are purchasing loans from nonbank third parties and are relying on third-party arrangements to facilitate the purchase of loans, including unsecured loans or loans underwritten using proprietary models that limit the purchasing institution's ability to assess underwriting quality, credit quality, and adequacy of loan pricing," the FDIC wrote. "Although the FDIC strongly supports banks' efforts to prudently meet the credit needs of their communities, the FDIC expects institutions to exercise sound judgment and strong underwriting when originating and purchasing loans and loan participations."

To that end, the regulator explained its expectations for the policy guidelines of financial institutions. The bank must establish credit underwriting and administration requirements addressing the risks and characteristics unique to the loan types permitted for purchase and should outline procedures for purchased and participation loans, defining loan types that are acceptable for purchase. The policy should require thorough independent credit and collateral analysis, and mandate an assessment of the purchasing bank's rights, obligations, and limitations, the FDIC said.

Concentration limits need to be established as part of the policy and should take into account aggregate purchased loans and participations, out-of-territory purchased loans and participations, loans originated by individual lead or originating institutions, those loans and participations purchased through the same loan broker, and loan type.

The same degree of independent credit and collateral analysis are required for purchased loans or participations as loans originated with the bank, the FDIC emphasized. That means the institution must ensure it has "the requisite knowledge and expertise specific to the type of loans or participations purchased" and obtains all appropriate information. Banks need to consider whether the purchased loans are consistent with the board's risk appetite and comply with loan policy guidelines, both prior to commingling funds and on an ongoing basis. "This assessment and determination should not be contracted out to a third party," the guidance added.

If a financial institution relies upon a third party's credit models for decisions (such as consumer credits), the bank should perform due diligence to evaluate the validity of that model, the FDIC said. "Institutions are not prohibited from relying on a qualified and independent third party to perform model validation," the FDIC said. "However, the purchasing institution must review the model validation to determine if it is sufficient. Such review should be performed by staff that has the requisite knowledge and expertise to understand the validation."

A profit analysis is necessary, the regulator told banks, taking into account the additional costs of obtaining any expertise to properly oversee the purchased loans, as well as the rate of return to determine whether it is commensurate with the level of risk taken.

FIL-49-2015 laid out the necessary information to be included in the written loan sale or participation agreement, from a full description of the roles and responsibilities of all parties to remedies upon default and bankruptcy to dispute resolution procedures. "Institutions should assess thoroughly and understand all the terms, conditions, and limitations of the loan purchase or participation agreements," the FDIC advised, including a possible obligation to make additional credit advances.

Any limitations that the sales or participation agreement places on the purchasing bank—such as the ability to sell or transfer its loan interest or participate in loan modifications—must also be understood, with the use of legal counsel when appropriate. The ability to transfer, sell, or assign its interest in the purchased loans or participations should also be a factor for institutions with regard to liquidity management and credit concentration limits.

For purchased loans out-of-territory or in unfamiliar markets, the FDIC suggested caution and "extensive" due diligence both at the time of the agreement and on a continuing basis, with management keeping an eye on changing economic conditions.

The agency also reminded financial institutions of the need to comply with all existing regulations and requirements, incorporating the purchased loans into the bank's audit and review program, for example, reporting the interests in accordance with generally accepted accounting principles, and ensuring continued compliance with Bank Secrecy Act and anti-money laundering rules.

To read FIL-49-2015, click here.