written by Josh Beaird
Loan participations have become an important tool for community banks in this highly competitive financial environment. As the economy expands and loan demand increases, participations can benefit banks that are on both the selling side and purchasing side.
Many banks in faster-growing urban areas are facing situations where borrowers are bumping against legal lending limits, or the bank simply wants to diversify their asset base. Through the selling of participations, lenders can reduce credit risk, increase capital, and provide liquidity for new lending opportunities. On the purchasing side, banks in slower growth markets could put their strong deposit base to use in higher yielding assets. Although there are significant benefits, banks need to be aware of the risks and ensure proper controls are in place. Accounting, legal, regulatory, and operational roles must all be considered.
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The first step is having a strong participation agreement that clearly outlines the responsibilities of both parties. Most banks use standard forms from their document vendor, or attorney prepared agreements. However, the bank should establish a process to review all agreements, especially when updates are made to vendor systems. Certain provisions that may be included in participation agreements could prohibit sale accounting treatment and, therefore, not meet the goals of the participating banks.
If sale accounting treatment is not allowed, then the participation becomes a secured borrowing, where the purchasing bank is essentially lending money to the selling bank, that is secured by the participated loan balance. For the selling bank, this means they would have to recognize the full amount of the loan on their books. For the purchasing bank, they would be lending money to another bank, not a traditional customer.
Financial Accounting Standards Board (FASB) ASC 860-10-40 provides the guidelines for sale accounting treatment of a participation. To comply with the standard, a lead bank should ensure a participation agreement meets the following conditions:
- Each participant has a proportionate ownership interest (pro rata) in the asset. In other words, no party to the participation has priority over another.
- All cash flows are divided proportionately among the participants in an amount equal to their ownership share.
- As in the ownership interest, all parties have the same priority to cash flows and participants have no recourse to the lead bank, other than standard representations and warranties.
- No party can unilaterally pledge or exchange the entire asset.
The most common issues we have seen, which violate these conditions, include the following:
- The interest rate that passes-through to the purchasing bank is different from the contractual loan rate. This is typically intended to compensate the lead bank for servicing but causes cash flows to be divided disproportionately. In these cases, it is important do document what is justifiable compensation for loan servicing.
- Provisions that give the originating bank the option to unilaterally repurchase the participated portion of a loan. This gives the lead bank unequal control over the asset. In contrast, “Right of first refusal” provisions, when the participant wishes to sell their interest, are generally acceptable. This is because the participant is not being required to sell and ends up in the same economic position.
- Provisions that require the participating bank to receive permission from the lead bank to sell or pledge their interest in the loan. Again, this gives the lead bank unequal control. Two common statements that can alleviate this issue include:
- Permission that is “not to be unreasonably withheld” by the lead bank, or
- “No party shall pledge the entire Loan without the written consent of all other participants”, which gives equal priority to all parties.
From an internal control perspective, banks should consider consulting with their accountants and obtaining legal opinions for significant agreements or non-standard agreements, so they are not subsequently derecognized for sale accounting treatment. Furthermore, control processes should include careful evaluation of any changes made by loan document vendors to standardized forms. IT personnel may need to be involved and notify lending staff of software updates that change default settings in loan package software.
Finally, personnel with accounting knowledge, perhaps at the CFO level, should also be involved in the process to periodically review forms provided by vendors. “Set it and forget it” is not an option in the current environment where regulations and accounting standards are constantly changing. The key is to be sure that document language reflects the intentions of the bank to recognize loan sale treatment.
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Purchasing banks should follow the same underwriting standards and approval process for participated loans, as they do for in-house originations. Perhaps, even more scrutiny should be applied to purchased participations, since your lenders do not have a relationship with the borrower.
There is also risk to participants that a lead bank will wish to purchase back loans as their legal lending limit increases. Although this should not be contractually obligated, most participants will comply to maintain a positive relationship for future transactions. If banks rely on participations as a significant source of investment, strategic planning should include the prospect of buy-backs.
Loan participations can provide significant benefits to community banks. However, each participation should be considered carefully so undue risk, legal lending limit issues, and capital adequacy concerns are avoided.
Contact The Whitlock Co. to request a consultation or call 417-881-0145 for more information regarding loan participations. We serve Kansas City, Springfield, and Joplin in Missouri. Our team has specific expertise to benefit your bank