Alert April 02, 2013

FRB, FDIC and OCC Issue Updated Guidance Concerning Leveraged Lending

The FRB, FDIC and OCC (the “Agencies”) jointly issued final updated guidance (the “Interagency Guidance”) concerning leveraged lending.  The Interagency Guidance updates guidance issued in April 2001.  The Agencies issued a proposed version of the Interagency Guidance on March 30, 2012 and requested public comment on the proposal, and the Interagency Guidance makes certain modifications to the initial proposal that reflect certain of the comments received by the Agencies.  The proposed version of the Interagency Guidance was discussed in the April 3, 2012 Financial Services Alert.  The Interagency Guidance describes the Agencies’ expectations regarding a financial institution’s sound risk management of leveraged lending activities.

The Agencies generally regard leveraged lending as a lending transaction characterized by a borrower with a degree of financial or cash flow leverage that significantly exceeds industry norms or historical standards as measured by various debt, cash flow or other ratios.  The Agencies state, however, that a financial institution engaged in leveraged lending should incorporate into its credit policies a definition that is appropriate to the financial institution and its business.  Moreover, the Interagency Guidance notes certain benchmarks that each financial institution’s definition should cover, e.g., a loan facility to a borrower with a total debt/EBITDA ratio of more than 4:1 or senior debt EBITDA of more than 3:1 is likely to be viewed by the Agencies as a leveraged loan.  The Agencies state that the Interagency Guidance provides high-level principles related to safe and sound leveraged lending that the Agencies expect a financial institution to consider before making a leveraged loan and during the administration of such a loan. 

The Interagency Guidance advises lenders to focus on, among other things:

  1. identification of the financial institution’s risk appetite for leveraged lending (how much of such risk will be underwritten, and how much risk will be retained?);
  2. risk management frameworks (e.g., credit limits, volume limits on leveraged finance transactions);
  3. underwriting standards (e.g., cash flow capacity, covenant protection, collateral control);
  4. valuation standards (determination of, and updates to, calculations and documentation of a borrower’s enterprise value);
  5. timely measurement of transactions “in the pipeline” (e.g., need for periodic stress tests).
  6. independent evaluation by purchaser of participations in leveraged loans of the risks assumed and the transaction as a whole;
  7. risk management and controls over transactions in the pipeline (taking into account potential market disruptions and failed transactions);
  8. reporting and analysis (e.g., information systems that accurately capture key obligor characteristics and aggregate them across business lines and legal entities); and
  9. stress testing of leveraged loans held in portfolio as well as those planned for distribution.

The Agencies point out that there are few community banks with substantial involvement in leveraged lending and, accordingly, the Interagency Guidance should not have a substantial effect on community banks.  The Agencies also state that the Interagency Guidance does not apply to traditional asset-based loans.  The Interagency Guidance became effective on March 22, 2013, but the compliance deadline for the Interagency Guidance is May 21, 2013.