Depository institutions use loan participations as an integral part of their lending operations. Banks may sell participations to enhance their liquidity, interest rate risk management, and capital and earnings. Generally, participation loans are typically traded between banks with established relationships, such as non-competing banks in different market areas, bankers’ banks and correspondent banks.
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Buying and Selling Participations
A primary advantage of participations loans is to diversify a Bank’s loan portfolio and serve the credit needs of borrowers. Buying participation loans enables community banks with large deposit volumes but low loan demand in their local market area to loan out these deposits by participating in loans made by banks outside their immediate area.
Selling participations may enable community banks to meet the credit needs of customers they might otherwise have to turn away to avoid exceeding their legal lending limits, diversify their portfolios by industry and/or geography, or to comply with regulatory rules governing insider loans. The amount of money banks can lend to business owners who serve on their board of directors is limited by Regulation O, but participation loans are one way to legally comply with this limit.
The Importance of the Participation Agreement
The purchase of loans and participations in loans may constitute an unsafe or unsound banking practice in the absence of satisfactory documentation, credit analysis, and other controls over risk. If your bank is new to participation lending, you should be aware of the differences between participations and normal bank loans, as well as other participation loan nuances. The first thing to keep in mind is the importance of the participation agreement.
This agreement should include the specific rights and responsibilities of the buying and selling bank, as well as all pertinent details of the loan itself (e.g., loan servicing). In addition, the agreement should address each bank’s rights and responsibilities in the event the borrower is not performing per the loan agreement. Through the participation agreement, each bank should be aware of the decision making process, loan renewal procedures, foreclosure procedures, etc.
In particular, both banks should be in agreement about the loan’s credit risk ratings. The selling bank should be required to provide regular financial information regarding the credit to the buying bank, as well as keep the buying bank informed on a regular basis about all aspects of the loan.
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Whether a buyer or seller, each bank should underwrite participation loans in the same way they would underwrite any other loan. As a buyer, this includes performing your own due diligence on the borrower, reviewing any appraisal and environmental issues associated with the loan, and obtaining a complete underwriting package from the selling bank.