Many community banks rely on participation loans as a source of alternative funds for lending. Selling participation loans may enable banks to meet their borrowers’ financing needs when loan amounts exceed the bank’s lending capacity, whether legal or self-imposed.
Buying participation loans can help community banks grow their loan volume and diversify their portfolios. Typically, participation loans are traded between banks that have established relationships with each other.
Community banks buy and sell participation loans for a number of different reasons, including:
- To meet the credit needs of growing small businesses. Without participations, community banks could find themselves unable to meet a growing small business customer’s credit needs — and then watch this customer leave for a larger bank that can. Participations may also enable community banks to provide a wider variety of financing alternatives to borrowers.
- To build loan volume. If a bank is sitting on excess deposits but there is a lack of loan demand in its local market area, it can loan out these deposits by buying participations from other banks outside its area.
- To diversify their loan portfolio. Participation loans can help diversify a portfolio by industry or geography. For example, if a bank’s region is dominated by a particular industry (such as agriculture), it might consider selling participations in agriculture loans to banks in other regions, thereby preserving deposits to lend to businesses in other industries.
Similarly, if a bank’s market area for making small business loans is limited to a particular radius, its portfolio could be vulnerable to fluctuations in the local economy or market conditions. Selling participation loans to banks outside this area could help spread out this risk geographically.
- To lend to directors. Regulation O places limitations on how much money community banks can lend to small business owners who are on their board of directors. Participations are a way to legally lend to credit-worthy directors in excess of these limitations.
Whether your bank is new to participation lending or has been buying and selling participations for awhile, there are some nuances you should keep in mind. Here are four participation loan guidelines to follow:
1. Be sure the participation agreement spells out the rights and responsibilities of both banks. The bank purchasing the participation should have the right to receive regular financial information from the selling bank, which should keep the buying bank regularly informed about all aspects of the credit.
Most banks have their own participation agreements, so you may need to negotiate which one to use, or create a new agreement that incorporates elements of both. All the details of the loan and the participation should be spelled out in the agreement, including but not limited to:
- Loan servicing
- Which bank assumes how much credit risk
- The rights and responsibilities of the participating parties if the loan becomes troubled
2. Make sure both banks are in agreement about credit risk ratings. There’s no single accepted industry standard for risk ratings (like Moody’s bond ratings) — a “3” in one bank, for example, might be a “5” in another bank. Consider using Moody’s RiskCalc™ or KMV to quantify the credit risk of companies across different industries and size ranges in a consistent framework.
3. Perform due diligence on any other banks you’re considering participating with, carefully examining their underwriting and monitoring processes, expertise, the historical quality of their loan portfolio, etc. The same goes for the participating bank’s market area.
4. Most importantly, you should apply the same underwriting guidelines to participation loans that you do to loans your own bank originates. Also be sure to obtain a complete underwriting package from the participating bank.
If certain conditions are not met in the participation agreement, a transaction will be treated as a borrowing and the loan will not be removed from the books. This is something banks should obviously try to avoid.
We can help you weigh the pros and cons of buying and selling participation loans. To learn more, please contact us today.