The federal financial institution regulators want to avoid a repeat of risky lending practices that contributed to the recent recession. New guidance sets higher standards for borrowers, including private equity firms and companies, seeking leveraged loans.
“This is a proactive move on the part of bank regulators to avoid some of the underwriting pitfalls that institutions encountered prior to the recessionary conditions we had going into 2007 and 2008,” says Dickie Heathcott, a partner at Crowe Horwath LLP.
Smart Business spoke to Heathcott about the guidance — which had a compliance date of May 21 — and what it means for borrowers and financial institutions.
What is the guidance, and do financial institutions have to adhere to its provisions?
Although a guidance isn’t necessarily a rule, it effectively becomes one in the field. Banks have to follow it because that’s what regulators are going to use when they examine the bank.
The guidance, issued by the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC), covers transactions with borrowers who have a degree of financial leverage that significantly exceeds industry norms.
It focuses on sound, levered lending activities, including:
• Underwriting considerations.
• Assessing and documenting enterprise value.
• Risk management expectations for credits awaiting distribution.
• Stress-testing expectations.
• Pipeline portfolio management.
• Risk management expectations for exposures held by the institution.
The guidance applies to all financial institutions supervised by the agencies, but significant impacts are not expected for community banks because few have substantial involvement in leveraged lending.
Are there certain industries where leveraged lending is of particular concern?
Construction and development lending is being looked at very closely because of what’s happened in recent years. This type of lending is generally considered commercial real estate lending.
The OCC and the Fed released a white paper in April with findings from the regulators’ study of bank performance in the context of the 2006 interagency guidance, “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.” That guidance established supervisory criteria for banks that exceeded 100 percent of capital in construction lending and 300 percent of capital in total commercial real estate lending.
According to the paper:
• 13 percent of banks that exceeded the 100 percent construction-lending criterion failed during the economic downturn from 2008 to 2011.
• 23 percent of banks that exceeded both the construction and commercial real estate criteria failed from 2008 to 2011, compared to 0.5 percent of banks that exceeded neither criteria.
• An estimated 80 percent of losses in the FDIC fund from 2007 to 2011 were attributed to banks exceeding the 100 percent construction-lending criterion.
What does the guidance mean for businesses seeking loans?
Business owners can look for financial institutions to be very cautious in their underwriting. They will not have access to credit like they did in 2006, even though it seems that the economy has stabilized.
Regulators are being proactive; they can see that credit underwriting is loosening up. Quality deals are being priced so thin that financial institutions are looking at areas where they can make more profit, which, of course, brings additional risk.
From a financial institution standpoint, it’s becoming a very competitive environment again. That means pricing more thinly or a loosening of underwriting standards. Institutions may be willing to finance certain types of loans they would have pulled the reins in on completely three or four years ago. The guidance is about ensuring that to the extent institutions enter into leveraged financing again, they do so in a more prudent manner.
Dickie Heathcott is a partner at Crowe Horwath LLP. Reach him at (214) 777-5254 or [email protected]
Website: For more information on regulatory guidance for financial institutions, visit Crowe’s Regulatory Reform Competency Center.
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