Federal bank regulators have released updated supervisory guidance on leveraged lending.

The guidance, issued on Thursday by the Federal Reserve Board, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, covers transactions characterized by a borrower with “a degree of financial leverage that significantly exceeds industry norms.” It updates guidance issued in April 2001.

Announcing the update, regulators explained that before the financial crisis the volume of leveraged credit transactions grew tremendously and participation by non-regulated investors willing to accept looser terms increased. While leveraged lending declined during the crisis, volumes have since increased and underwriting practices have deteriorated.

The new guidance focuses on the following areas:

  • The agencies expect that management and the board of directors identify the institution's risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes.
  • Underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower's capital structure is sustainable, regardless of whether the transaction is underwritten to hold or to distribute.
  • Valuation standards should concentrate on the importance of sound methods in the determination and periodic re-validation of enterprise value.
  • An institution should be able to accurately measure exposure on a timely basis; establish policies and procedures that address failed transactions and general market disruptions; and ensure periodic stress tests of exposures to loans not yet distributed to buyers.
  • An institution's risk rating standards should consider the use of realistic repayment assumptions to determine a borrower's ability to de-lever to a sustainable level within a reasonable period of time.
  • An institution that participates in leveraged loans should establish underwriting and monitoring standards similar to loans underwritten internally.
  • An institution should perform stress testing on leveraged loans held in portfolio as well as those planned for distribution, in accordance with existing inter-agency issuances.

In comment letters received prior to a June 2012 deadline, there was concern about the potential effect the proposed guidance would have on community banks and mid-sized institutions. One commenter noted that community banks with an insignificant amount of leveraged lending should not have to follow the same risk management framework as financial institutions with significant amounts of leveraged lending; others suggested that the proposed guidance should exclude financial institutions under a certain asset or capital size, or exclude transactions under a certain dollar threshold.

In response, the agencies decided to apply the final guidance to all financial institutions that originate or participate in leveraged lending transactions. They agreed, however, that a financial institution that originates a small number of less complex leveraged loans should not be expected to have policies and procedures commensurate with those of a larger financial institution with a more complex leveraged loan origination business.

There was also a request that the definition of leveraged lending be modified so as not to include “fallen angels,” loans that do not meet the definition of leverage loans at origination, but migrate into it at a later date due to changes in the borrower's financial condition. The regulators agreed that these should not be included as leveraged lending transactions, but should be captured within the financial institution's broader risk management framework. The final guidance clarifies that a loan should be designated as leveraged only at the time of origination, modification, extension, or refinance.

This guidance is effective on March 22, 2013 with a compliance date of May 21, 2013.