Federal Register, Volume 77 Issue 62 (Friday, March 30, 2012)

[Federal Register Volume 77, Number 62 (Friday, March 30, 2012)]
[Notices]
[Pages 19417-19424]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-7620]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

[Docket ID OCC-2011-0028]

FEDERAL RESERVE SYSTEM

[OP-1439]

FEDERAL DEPOSIT INSURANCE CORPORATION

Proposed Guidance on Leveraged Lending

AGENCY: Office of the Comptroller of the Currency, Treasury (``OCC'');
Board of Governors of the Federal Reserve System (``Board'' or
``Federal Reserve''); and the Federal Deposit Insurance Corporation
(``FDIC'').

ACTION: Proposed joint guidance with request for public comment.

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SUMMARY: The OCC, Board, and the FDIC (collectively, the Agencies)
request comment on proposed guidance on leveraged lending (proposed
guidance).

[[Page 19418]]

The proposed guidance outlines high-level principles related to safe
and sound leveraged lending activities, including underwriting
considerations, assessing and documenting enterprise value, risk
management expectations for credits awaiting distribution, stress
testing expectations and portfolio management, and risk management
expectations. This proposed guidance would apply to all Federal
Reserve-supervised, FDIC-supervised, and OCC-supervised financial
institutions substantively engaged in leveraged lending activities. The
number of community banking organizations with substantial exposure to
leveraged lending is very small; therefore the Agencies generally
expect that community banking organizations largely would be unaffected
by this guidance.

DATES: Comments must be submitted on or before June 8, 2012.

ADDRESSES:

OCC

Please use the title ``Proposed Leveraged Lending Guidance'' to
facilitate the organization and distribution of the comments. You may
submit comments by any of the following methods:
Email: regs.comments@occ.treas.gov.
Mail: Office of the Comptroller of the Currency, 250 E
Street SW., Mail Stop 2-3, Washington, DC 20219.
Fax: (202) 874-5274.
Hand Delivery/Courier: 250 E Street SW., Mail Stop 2-3,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket Number OCC-2011-0028'' in your comment. In general, OCC will
enter all comments received into the docket and publish them on the
Regulations.gov Web site without change, including any business or
personal information that you provide such as name and address
information, email addresses, or phone numbers. Comments received,
including attachments and other supporting materials, are part of the
public record and subject to public disclosure. Do not enclose any
information in your comment or supporting materials that you consider
confidential or inappropriate for public disclosure.
You may review comments and other related materials that pertain to
this notice by any of the following methods:
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC, 250 E Street SW., Washington, DC.
For security reasons, the OCC requires that visitors make an
appointment to inspect comments. You may do so by calling (202) 874-
4700. Upon arrival, visitors will be required to present valid
government-issued photo identification and to submit to security
screening in order to inspect and photocopy comments.
Docket: You may also view or request available background
documents and project summaries using the methods described above.

Board

When submitting comments, please consider submitting your comments
by email or fax because paper mail in the Washington, DC, area and at
the Board may be subject to delay. You may submit comments, identified
by Docket No. OP-1439, by any of the following methods:
Agency Web Site: http://www.federalreserve.gov. Follow the
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Email: regs.comments@federalreserve.gov. Include docket
number in the subject line of the message.
FAX: (202) 452-3819 or (202) 452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue NW.,
Washington, DC 20551.
All public comments are available from the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, unless modified for technical reasons. Accordingly, your
comments will not be edited to remove any identifying or contact
information. Public comments may also be viewed electronically or in
paper form in Room MP-500 of the Board's Martin Building (20th and C
Street NW., Washington, DC 20551) between 9 a.m. and 5 p.m. on
weekdays.
FDIC: You may submit comments by any of the following methods:
Agency Web site: http://www.FDIC.gov/regulations/laws/federal/propose.html. Follow the instructions for submitting comments.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Email: comments@FDIC.gov. Include ``Leveraged Lending
Guidance'' in the subject line of the message. Comments received will
be posted without change to http://www.FDIC.gov/regulations/laws/federal/propose.html, including any personal information provided.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments/Legal ESS, Federal Deposit Insurance Corporation, 550 17th
Street NW., Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street), on business days
between 7 a.m. and 5 p.m. (EDT).

FOR FURTHER INFORMATION CONTACT:
OCC: Louise Francis, Commercial Credit Technical Expert, 202-874-
5170, 250 E Street SW., Washington, DC 20219.
Board: Lawrence A. Rufrano, Senior Financial Analyst, (202) 452-
2808, Mary Aiken, Manager, Risk Policy, (202) 452-2904, or Benjamin W.
McDonough, Senior Counsel, (202) 452-2036, Legal Division, Board of
Governors of the Federal Reserve System, 20th and C Streets NW.,
Washington, DC 20551.
FDIC: William R. Baxter, Senior Examination Specialist, 202-898-
8514, wbaxter@fdic.gov, 550 17th Street NW., Washington, DC 20429.

SUPPLEMENTARY INFORMATION:

I. Background

All financial institutions \1\ should have the capacity to properly
evaluate and monitor underwritten credit risks, to understand the
effect of changes in borrowers' enterprise values upon credit portfolio
quality, and to assess the sensitivity of future credit losses to
changes in enterprise values. Further, in underwriting such credits,
institutions need to ensure that borrowers are able to repay credit as
due and at the same time that borrowers have capital structures,
including their bank borrowings and other debt, that support the
borrower's continued operations through economic cycles (that is, have
a sustainable capital structure). Institutions should also be able to
demonstrate that they understand their risks and the potential impact
of stressful events and circumstances on borrowers' financial
condition. The Agencies have previously provided guidance to financial
institutions for their involvement in leveraged lending. The recent
financial crisis further underscored the need for banking organizations
to employ sound

[[Page 19419]]

underwriting, to ensure that the risks in leveraged lending activities
are appropriately incorporated in the Allowance for Loan and Lease
Losses and capital adequacy analyses, to monitor the sustainability of
their borrowers' capital structures, and to incorporate stress testing
into their risk management of both leveraged portfolios and
distribution pipelines, as banking organizations unprepared for
stressful events and circumstances can suffer acute threats to their
financial condition and viability. The proposed guidance is intended to
be consistent with industry practices while building upon the recently
proposed guidance on Stress Testing.\2\
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\1\ For purposes of this guidance, the term ``financial
institution'' means national banks, federal savings associations,
and Federal branches and agencies supervised by the OCC; state
member banks, bank holding companies, and all other institutions for
which the Federal Reserve is the primary federal supervisor; and
state nonmember insured banks and other institutions supervised by
the FDIC.
\2\ ``Annual Stress Test,'' Notice of Proposed Rulemaking, 77 FR
3408 (January 24, 2012).
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II. Principal Elements of the Proposed Guidance

In April 2001, the Agencies (and Office of Thrift Supervision)
issued guidance \3\ regarding sound practices for leveraged finance \4\
activities (2001 Guidance). The 2001 Guidance addressed expectations
for the content of credit policies, the need for well-defined
underwriting standards, the importance of defining an institution's
risk appetite for leveraged transactions, and the importance of stress
testing exposures and portfolios.
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\3\ SR 01-9, ``Interagency Guidance on Leveraged Financing,''
April 17, 2001, OCC Bulletin 2001-8, FDIC Press Release PR-28-2001.
\4\ For the purpose of this guidance, references to leveraged
finance or leveraged transactions encompass the entire debt
structure of a leveraged obligor (including senior loans and letters
of credit, mezzanine tranches, senior and subordinated bonds).
References to leveraged lending and leveraged loan transactions and
credit agreements refer to the senior loan and letter of credit
tranches held by both bank and non-bank investors.
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Since the issuance of that guidance, the Agencies have observed
tremendous growth in the volume of leveraged credit and in the
participation of non-regulated investors. As the market has grown, debt
agreements have frequently included features that provided relatively
limited lender protection, including the absence of meaningful
maintenance covenants in loan agreements and the inclusion of payment-
in-kind (PIK)-toggle features in junior capital instruments (i.e., a
feature where the borrower has the option to pay interest in cash or
in-kind, which increases the principal owed), both of which lessen
lenders' recourse in the event that a borrower's performance does not
meet projections. Further, the capital structures and repayment
prospects for some transactions, whether originated to hold or
distribute, have at times been aggressive in light of the overall risk
of the credit.
Absent meaningful limits and to support burgeoning demand from
institutional investors, the pipeline of aggressively priced and
structured commitments has grown rapidly. Further, management
information systems (MIS) at some institutions have proven less than
satisfactory in accurately aggregating exposures on a timely basis, and
many institutions have found themselves holding large pipelines of
higher-risk commitments at a time when buyer demand for risky assets
diminished significantly.
In light of these changes, the Agencies have decided to replace the
2001 Guidance with new leveraged finance guidance (proposed guidance).
The proposed guidance describes expectations for the sound risk
management of leveraged finance activities, including the importance of
institutions developing and maintaining:
Transactions that are structured to reflect a sound
business premise, an appropriate capital structure, and reasonable cash
flow and balance sheet leverage. Combined with supportable performance
projections, these considerations should clearly support a borrower's
capacity to repay and de-lever to a sustainable level over a reasonable
period, whether underwritten to hold or distribute.
A definition of leveraged finance that facilitates
consistent application across all business lines.
Well-defined underwriting standards that, among other
things, define acceptable leverage levels and describe amortization
expectations for senior and subordinate debt.
A credit limit and concentration framework that is
consistent with the institution's risk appetite.
Sound MIS that enable management to identify, aggregate,
and monitor leveraged exposures and comply with policy across all
business lines.
Strong pipeline management policies and procedures that,
among other things, provide for real-time information on exposures and
limits, and exceptions to the timing of expected distributions and
approved hold levels.
The proposed guidance replaces existing leveraged finance guidance
and forms the basis of the Agencies' supervisory focus and review of
supervised financial institutions, including, as applicable,
subsidiaries and affiliates involved in leveraged lending. In
implementing the guidance, the Agencies will consider the size and risk
profile of an institution's leveraged portfolio relative to its assets,
earnings, liquidity, and capital. Although some sections of this
proposal are intended to apply to all leveraged lending transactions
(e.g., underwriting), the vast majority of community banks should not
be affected by this guidance as they have no exposure to leveraged
credits. The limited number of community and smaller institutions that
are involved in leveraged lending activities should discuss with their
primary regulator implementation of cost-effective controls appropriate
for the complexity of their exposures and activities.

III. Administrative Law Matters

A. Paperwork Reduction Act Analysis

In accordance with the Paperwork Reduction Act (PRA) of 1995 (44
U.S.C. 3506; 5 CFR part 1320, Appendix A.1), the Agencies reviewed the
proposed guidance. The Agencies may not conduct or sponsor, and an
organization is not required to respond to, an information collection
unless the information collection displays a currently valid OMB
control number. The Agencies have determined that certain aspects of
the proposed guidance may constitute a collection of information. In
particular, these aspects are the provisions that state a banking
organization should (i) have underwriting policies for leveraged
lending, including stress testing procedures for leveraged credits;
(ii) have risk management policies, including stress testing procedures
for pipeline exposures; and (iii) have policies and procedures for
incorporating the results of leveraged credit and pipeline stress tests
into the firm's overall stress testing framework. The frequency of
information collection is estimated to be annual. Respondents are
banking organizations with leveraged lending activities as defined in
the guidance.
Report Title: Guidance on Leveraged Lending.
Frequency of Response: Annual.
Affected Public: Banking Organizations with Leveraged Lending.

OCC

OMB Control No.: To be assigned by OMB.
Estimated number of respondents: 25.
Estimated average time per respondent: 1,350.4 hours to build;
1,705.6 hours for ongoing use.
Estimated total annual burden hours: 33,760 hours to build, 42,640
hours for ongoing use.

Board

Agency information collection number: FR 4203.

[[Page 19420]]

OMB Control No.: To be assigned by OMB.
Estimated number of respondents: 41.
Estimated average time per respondent: 1,064.4 hours to build,
754.4 hours for ongoing use.
Estimated total annual burden hours: 43,640 hours to build; 30,930
hours for ongoing use.

FDIC

OMB Control No.: To be assigned by OMB.
Estimated number of respondents: 9.
Estimated average time per respondent: 986.7 hours to build; 529.3
hours for ongoing use.
Estimated total annual burden hours: 8,880 hours to build, 4,764
hours for ongoing use.
The estimated time per respondent is an average that varies by
agency because of differences in the composition of the institutions
under each agency's supervision (e.g., size distribution of
institutions) and volume of leveraged lending activities.
The Agencies invite comments on the following:
(1) Whether the proposed collection of information is necessary for
the proper performance of the regulatory function; including whether
the information has practical utility;
(2) The accuracy of the estimates of the burden of the proposed
information collection, including the cost of compliance;
(3) Ways to enhance the quality, utility, and clarity of the
information to be collected; and
(4) Ways to minimize the burden of information collection on
respondents, including through the use of automated collection
techniques or other forms of information technology.
Additionally, please send a copy of your comments regarding these
proposed information collections by mail to: Desk Officer, U.S. Office
of Management and Budget, 725 17th Street NW., 10235,
Washington, DC 20503, or by fax to (202) 395-6974.
These information collections are authorized pursuant to the
following statutory authorities:
OCC: National Bank Act, (12 U.S.C. 1 et seq.; 12 U.S.C. 161) and
the International Banking Act (12 U.S.C. 3101 et seq.)
Board: Sections 11(a), 11(i), 25, and 25A of the Federal Reserve
Act (12 U.S.C. 248(a), 248(i), 602, and 611), section 5 of the Bank
Holding Company Act (12 U.S.C. 1844), and section 7(c) of the
International Banking Act (12 U.S.C. 3105(c)).
FDIC: Federal Deposit Insurance Act, (12 U.S.C. 1811 et seq.) and
the International Banking Act (12 U.S.C. 3101 et seq.).
The agencies expect to review the policies and procedures for
stress testing as part of their supervisory processes. To the extent
they collect information during an examination of a banking
organization, confidential treatment may be afforded to the records
under exemption 8 of the Freedom of Information Act (FOIA), 5 U.S.C.
552(b)(8).

B. Regulatory Flexibility Act Analysis

While the guidance is not being adopted as a rule, the Agencies
have considered the potential impact of the proposed guidance on small
banking organizations using the considerations that would apply if the
Regulatory Flexibility Act (5 U.S.C. 603(b)) were applicable. For the
reason discussed in the Supplementary Information above, the Agencies
are issuing the proposed guidance to emphasize the importance of
properly underwriting leveraged lending transactions and incorporating
those exposures into stress and capital tests for institutions with
significant exposures to these credits. Based on its analysis and for
the reasons stated below, the Agencies believe that the proposed
guidance will not have a significant economic impact on a substantial
number of small entities. Nevertheless, the Agencies are seeking
comment on whether the proposed guidance would impose undue burdens on,
or have unintended consequences for, small organizations.
Under regulations issued by the Small Business Administration
(SBA), a small banking organization is defined as a banking
organization with total assets of $175 million or less. See 13 CFR
121.201. The guidance being proposed by the Agencies is intended for
banking organizations supervised by the Agencies with substantial
exposures to leveraged lending activities, including national banks,
federal savings associations, state nonmember banks, state member
banks, bank holding companies, and U.S. branches and Agencies of
foreign banking organizations. Given the sheer size of leveraged
lending transactions, most of which exceed $50 million, and the
Agencies' observations that leveraged loans tend to be held primarily
by large or global banking institutions with total assets that are well
above $175 million, the effects of this guidance upon smaller
institutions are expected to be negligible. Banking organizations that
are subject to the proposed guidance therefore substantially exceed the
$175 million total asset threshold at which a banking organization is
considered a small banking organization under SBA regulations.
In light of the foregoing, the Agencies believe that the proposed
guidance, if adopted in final form, would not have a significant
economic impact on a substantial number of small entities. As noted
above, the Agencies specifically seek comment on whether the proposed
guidance would impose undue burdens on, or have unintended consequences
for, small organizations and whether there are ways such potential
burdens or consequences could be addressed in a manner consistent with
the guidance.

IV. Proposed Guidance

The text of the proposed guidance is as follows:

Purpose

In April 2001, the Agencies (Office of the Comptroller of the
Currency, Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, and Office of Thrift Supervision)
issued guidance \5\ regarding sound practices for leveraged finance
\6\ activities (2001 Guidance). The 2001 Guidance addressed
expectations for the content of credit policies, the need for well-
defined underwriting standards, the importance of defining an
institution's risk appetite for leveraged transactions, and the
importance of stress testing exposures and portfolios.
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\5\ SR 01-9, ``Interagency Guidance on Leveraged Financing,''
April 17, 2001, OCC Bulletin 2001-8, FDIC Press Release PR-28-2001.
\6\ For the purpose of this guidance, references to leveraged
finance or leveraged transactions encompass the entire debt
structure of a leveraged obligor (including senior loans and letters
of credit, mezzanine tranches, senior and subordinated bonds).
References to leveraged lending and leveraged loan transactions and
credit agreements refer to the senior loan and letter of credit
tranches held by both bank and non-bank investors.
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[[Page 19421]]

commitments at a time when buyer demand for risky assets diminished
significantly.
In light of these changes, the Agencies have decided to replace
the 2001 Guidance with new leveraged finance guidance (2012
Guidance). The 2012 Guidance describes expectations for the sound
risk management of leveraged finance activities, including the
importance for institutions to develop and maintain:
Transactions that are structured to reflect a sound
business premise, an appropriate capital structure, and reasonable
cash flow and balance sheet leverage. Combined with supportable
performance projections, these should clearly support a borrower's
capacity to repay and de-lever to a sustainable level over a
reasonable period, whether underwritten to hold or distribute.
A definition of leveraged finance that facilitates
consistent application across all business lines.
Well-defined underwriting standards that, among other
things, define acceptable leverage levels and describe amortization
expectations for senior and subordinate debt.
A credit limit and concentration framework that is
consistent with the institution's risk appetite.
Sound MIS that enable management to identify,
aggregate, and monitor leveraged exposures and comply with policy
across all business lines.
Strong pipeline management policies and procedures
that, among other things, provide for real-time information on
exposures and limits, and exceptions to the timing of expected
distributions and approved hold levels.

Applicability

This issuance replaces existing leveraged finance guidance and
forms the basis of the Agencies' supervisory focus and review of
supervised financial institutions, including subsidiaries and
affiliates. Implementation of this guidance should be consistent
with the size and risk profile of an institution's leveraged
portfolio relative to its assets, earnings, liquidity, and capital.
Although some sections of this guidance should apply to all
leveraged transactions (e.g., underwriting), the vast majority of
community banks should not be affected by this guidance as they have
no exposure to leveraged credits. The limited number of community
and smaller institutions that have leveraged lending activities
should discuss with their primary regulator implementation of cost-
effective controls appropriate for the complexity of their exposures
and activities.

Risk Management Framework

Given the high risk profile of leveraged exposures, institutions
engaged in leveraged financing should adopt a risk management
framework that has an intensive and frequent review and monitoring
process. The framework should have as its foundation written risk
objectives, risk acceptance criteria, and risk controls. The lack of
robust risk management processes and controls in institutions with
significant leveraged finance activities could contribute to a
finding that the institution is engaged in an unsafe and unsound
banking practice. This guidance outlines minimum regulatory
expectations and covers the following topics:
Definition of Leveraged Finance.
General Policy Expectations.
Underwriting Standards.
Valuation Standards.
Pipeline Management.
Reporting and Analytics.
Rating Leveraged Loans.
Other Key Risk Management Components.
Credit Analysis.
Problem Credits.
Deal Sponsors.
Credit Review.
Conflicts of Interest.
Anti-tying.
Reputation Risk.
Securities Laws.
Compliance.

Definition of Leveraged Finance

Institutions' policies should include criteria to define
leveraged finance. Numerous definitions of leveraged finance exist
throughout the financial services industry and commonly contain some
combination of the following:
Proceeds are used for buyouts, acquisitions, or capital
distributions.
Transactions where the borrower's Total Debt/EBITDA
(earnings before interest, taxes, depreciation, and amortization) or
Senior Debt/EBITDA exceed 4.0X EBITDA or 3.0X EBITDA, respectively,
or other defined levels appropriate to the industry or sector.\7\
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\7\ Cash should not be netted against debt for purposes of this
calculation.
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Borrower that is recognized in the debt markets as a
highly leveraged firm, which is characterized by a high debt-to-net-
worth ratio.
Transactions where the borrower's post-financing
leverage, when measured by its leverage ratios, debt-to-assets,
debt-to-net-worth, debt-to-cash flow, or other similar standards
common to particular industries or sectors, significantly exceeds
industry norms or historical levels.\8\
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\8\ Higher quality borrowers not initially designated as part of
the leveraged portfolio, but which otherwise meet the institution's
definition, should be added to the portfolio if their financial
performance and prospects deteriorate (i.e., fallen angels).
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Institutions engaging in this type of activity should define
leveraged finance within their policies in a manner sufficiently
detailed to ensure consistent application across all business lines.
Examiners should expect the bank's definition to describe
clearly the purposes and financial characteristics common to these
transactions, and this definition should include the bank's exposure
to financial vehicles, whether or not leveraged, that engage in
leveraged finance activities.

General Policy Expectations

An institution's credit policies and procedures for leveraged
finance should address the following items:
Management should identify the institution's risk
appetite, which should include clearly defined amounts of leveraged
finance that the institution is willing to underwrite (pipeline
limits) and leveraged loans it is willing to retain (i.e.,
transaction and aggregate hold levels). The designated risk appetite
should be supported by an analysis of the potential effect on
earnings, capital, liquidity, and other risks that result from these
positions, and should be approved by the board of directors.
A limit framework that includes limits or guidelines
for single obligors and transactions, aggregate hold portfolio,
aggregate pipeline exposure, and industry and geographic
concentrations. The limit framework should identify the related
approval authorities and exception tracking provisions. In addition
to notional pipeline limits, underwriting limit frameworks that
assess stress losses, flex terms, economic capital usage, and
earnings at risk or otherwise provide a more nuanced view of
potential risk are expected from institutions with significant
leveraged finance exposure.
Ensuring that the risks of leveraged lending activities
are appropriately reflected in an institution's Allowance for Loan
and Lease Losses and capital adequacy analyses.
Credit and underwriting approval authorities, including
the procedures for approving and documenting changes to approved
transaction structures and terms.
Appropriate oversight by senior management, including
adequate and timely reporting to the board.
The expected risk-adjusted returns for leveraged
transactions.
Minimum underwriting standards (see Underwriting
Standards below).
The degree to which underwriting practices may differ
between primary loan origination and secondary loan acquisition.

Underwriting Standards

An institution's underwriting standards should be clear,
written, measurable, and accurately reflect the institution's risk
appetite for leveraged finance transactions. Institutions should
have clear underwriting limits regarding leveraged transactions,
including the size that the institution will arrange both
individually and in the aggregate for distribution. Originating
institutions should be mindful of reputational risks associated with
poorly underwritten transactions, which may find their way into a
wide variety of investment instruments and exacerbate systemic risks
within the general economy. At a minimum, underwriting standards
should consider:
Whether the business premise for each transaction is
sound and its capital structure is sustainable regardless of whether
the transaction is underwritten for the institution's own portfolio
or with the intent to distribute. The entirety of a borrower's
capital structure should reflect the application of sound financial
analysis and underwriting principles.
A borrower's capacity to repay and its ability to de-
lever to a sustainable level over a reasonable period. As a general
guide, base case cash-flow projections should show the ability over
a five-to-seven year period to fully amortize senior secured debt or
repay at least 50 percent of total debt. Projections should also
include one or more realistic downside scenarios that reflect the
key risks identified in the transaction.

[[Page 19422]]

Expectations for the depth and breadth of due diligence
on leveraged transactions. This should include standards for
evaluating various types of collateral, and it should clearly define
credit risk management's role in such due diligence.
Standards for evaluating expected risk-adjusted
returns. The standards should include identification of expected
distribution strategies, including alternative strategies for
funding and disposing of positions during market disruptions, and
the potential for losses during such periods.
Degree of reliance on enterprise value and other
intangible assets for loan repayment, along with acceptable
valuation methodologies, and guidelines for the frequency of
periodic reviews of those values.
Expectations for the degree of support provided by the
sponsor (if any), taking into consideration their financial
capacity, the extent of their capital contribution at inception, and
other motivating factors.
Whether credit agreement terms allow for the material
dilution, sale or exchange of collateral or cash flow-producing
assets without lender approval.
Credit agreement covenant protections, including
financial performance (such as debt to cash flow, interest coverage
or fixed charge coverage), reporting requirements, and compliance
monitoring. Generally, a leverage level after planned asset sales
(i.e., debt that must be serviced from operating cash flow) in
excess of 6x for Total Debt/EBITDA raises concerns for most
industries.
Collateral requirements in credit agreements that
specify acceptable collateral and risk-appropriate measures and
controls, including acceptable collateral types, loan-to-value
guidelines, and appropriate collateral valuation methodologies.
Standards for asset-based loans should also outline expectations for
the use of collateral controls (e.g., inspections, independent
valuations, and lockbox), other types of collateral and account
maintenance agreements, and periodic reporting requirements.
Whether loan agreements provide for distribution of
ongoing financial and other relevant credit information to all
participants/investors.
Nothing in the preceding standards should be considered to
discourage providing financing to borrowers engaged in workout
negotiations, or as part of a pre-packaged financing under the
bankruptcy code. Neither are they meant to discourage well-
structured standalone asset-based credit facilities to borrowers
with strong lender monitoring and controls, for which banks should
consider separate underwriting and risk rating guidance.

Valuation Standards

Lenders often rely upon enterprise value and other intangibles
when (1) evaluating the feasibility of a loan request, (2)
determining the debt reduction potential of planned asset sales, (3)
assessing a borrower's ability to access the capital markets, and
(4) estimating the strength of a secondary source of repayment.
Lenders may also view enterprise value as a useful benchmark for
assessing a sponsor's economic incentive to provide financial
support. Given the specialized knowledge needed for the development
of a credible enterprise valuation and the importance of enterprise
valuations in the underwriting and ongoing risk assessment
processes, enterprise valuations should be performed or validated by
qualified persons independent of the origination function.
Conventional appraisal theory provides three approaches for
valuing closely held businesses--asset, income, and market. Asset
approach methods consider an enterprise's underlying assets in terms
of its net going-concern or liquidation value. Income approach
methods consider an enterprise's ongoing cash flows or earnings and
apply appropriate capitalization or discounting techniques. Market
approach methods derive value multiples from comparable company data
or sales transactions. Although value estimates should reconcile
results from the use of all three approaches, the income approach is
generally considered the most common and reliable method. There are
two common methods to the income approach. The ``capitalized cash
flow'' method determines the value of a company as the present value
of all the future cash flows that the business can generate in
perpetuity. An appropriate cash flow is determined and then divided
by a risk-adjusted capitalization rate, most commonly the weighted
average cost of capital. This method is most appropriate when cash
flows are predictable and stable. The ``discounted cash flow''
method is a multiple-period valuation model that converts a future
series of cash flows into current value by discounting those cash
flows at a rate of return (discount rate) that reflects the risk
inherent therein and matches the cash flow. This method is most
appropriate when future cash flows are cyclical or variable between
periods. Both methods involve numerous assumptions, and supporting
documentation should therefore fully explain the evaluator's
reasoning and conclusions.
When an obligor is experiencing a financial downturn or facing
adverse market conditions, a lender should reflect those adverse
conditions in its assumptions for key variables such as cash flow,
earnings, and sales multiples when assessing enterprise value as a
potential source of repayment. Changes in the value of a firm's
assets should be tested under a range of stress scenarios, including
business conditions more adverse than the base case scenario. Stress
testing of enterprise values and their underlying assumptions should
be conducted and documented both at origination of the transaction
and periodically thereafter, incorporating the actual performance of
the borrower and any adjustments to projections. The institution
should perform its own discounted cash flow analysis to validate the
enterprise value implied by proxy measures such as multiples of cash
flow, earnings, or sales.
Valuations derived with even the most rigorous valuation
procedures are imprecise and ultimately may not be realized.
Therefore, institutions relying on enterprise value or illiquid and
hard-to-value collateral should have policies that provide for
appropriate loan-to-value ratios, discount rates, and collateral
margins. Based on the nature of an institution's leveraged lending
activities, establishing limits for the proportion of individual
transactions and the total portfolio that are supported by
enterprise value may be appropriate. Whatever the methodology,
assumptions underlying enterprise valuations should be clearly
documented, well supported, and understood by institutions'
appropriate decision-makers and risk oversight units. Examiners
should ensure that the valuation approach is appropriate for the
company's industry and condition.

Pipeline Management

Market disruptions can substantially impede the ability of an
underwriter to consummate syndications or otherwise sell down
exposures, which may result in material losses. Accordingly,
institutions should have strong risk management and controls over
transactions in the pipeline, including amounts to be held and those
to be distributed. An institution should be able to differentiate
transactions according to tenor, investor class (e.g., pro-rata,
institutional), structure, and key borrower characteristics (e.g.,
industry). In addition, an institution should develop and maintain:
A clearly articulated and documented appetite for
underwriting risk that considers the potential effects on earnings,
capital, liquidity, and other risks that result from these
positions.
Written procedures for defining and managing
distribution fails and ``hung'' deals, which are identified by an
inability to sell down the exposure within a reasonable period
(generally 90 days from closing). The institution's board should
establish clear expectations for the disposition of pipeline
transactions that have not been sold according to their original
distribution plan. Such transactions that are subsequently
reclassified as hold-to-maturity should also be included in reports
to management and the board of directors.
Guidelines for conducting periodic stress tests on
pipeline exposures to quantify the potential impact of changing
economic/market conditions on asset quality, earnings, liquidity,
and capital.
Controls to monitor performance of the pipeline against
original expectations, and regular reports of variances to
management, including the amount and timing of syndication/
distribution variances, and reporting if distribution was achieved
through a recourse sale.
Reports that include individual and aggregate
transaction information that accurately portrays risk and
concentrations in the pipeline.
Limits on aggregate pipeline commitments and periodic
testing of such exposures under different market scenarios.
Limits on the amount of loans that an institution is
willing to retain on its own books (i.e., borrower/counterparty and
aggregate hold levels), and limits on the underwriting risk that
will be undertaken for amounts intended for distribution.
Policies and procedures that identify acceptable
accounting methodologies and controls in both functional as well as

[[Page 19423]]

dysfunctional markets, and that direct prompt recognition of losses
in accordance with generally accepted accounting principles.
Policies and procedures addressing the use of hedging
to reduce pipeline and hold exposures. Policies should address
acceptable types of hedges and the terms considered necessary for
providing hedge credit (netting) for exposure measurement.
Plans and provisions addressing contingent liquidity
and compliance with Regulation W (12 CFR part 223) when market
illiquidity or credit conditions change, interrupting normal
distribution channels.

Reporting and Analytics

The Agencies expect financial institutions to diligently monitor
higher risk credits, including leveraged loans. An institution's
management should receive comprehensive reports about the
characteristics and trends in such exposures at least quarterly, and
summaries should be provided to the board of directors. Policies
should identify the fields to be populated and captured by an
institution's MIS, which should yield accurate and timely reporting
to management and the board that may include:
Individual and portfolio exposures within and across
all business lines and legal vehicles, including the pipeline.
Risk rating distribution and migration analysis,
including maintenance of a list of those borrowers who have been
removed from the leveraged portfolio due to changes in their
financial characteristics and overall risk profile.
Industry mix and maturity profile.
Metrics derived from probabilities of default and loss
given default.
Portfolio performance measures, including noncompliance
with covenants, restructurings, delinquencies, non-performing
amounts and charge-offs.
Amount of impaired assets and the nature of impairment
(i.e., permanent, temporary), and the amount of the Allowance for
Loan and Lease Losses attributable to leveraged lending.
The aggregate level of policy exceptions and the
performance of that portfolio.
Exposure by collateral type, including unsecured
transactions and those where enterprise value is a source of
repayment for leveraged loans. Reporting should also consider the
implications of defaults that trigger pari passu treatment for all
lenders and thus dilute secondary support from collateral value.
Secondary market pricing data and trading volume when
available.
Exposure and performance by deal sponsor.
Gross and net exposures, hedge counterparty
concentrations, and policy exceptions.
Actual versus projected distribution of the syndicated
pipeline, with regular reports of excess levels over the hold
targets for syndication inventory. Pipeline definitions should
clearly identify the type of exposure (e.g., committed exposures
that have not been accepted by the borrower, commitments accepted
but not closed, and funded and unfunded commitments that have closed
but have not been distributed).
Guidelines for conducting periodic portfolio stress
tests (including pipeline exposures) or sensitivity analyses to
quantify the potential impact of changing economic/market conditions
on asset quality, earnings, liquidity, and capital. The
sophistication of stress-testing practices and sensitivity analysis
should be consistent with the size, complexity, and risk
characteristics of the leveraged loan portfolio. The leveraged
portfolio also should be included in any enterprise-wide stress
tests.
Total and segment leveraged finance exposures,
including subordinated debt and equity holdings, alongside
established limits. Reports should provide a detailed and
comprehensive view of global exposure, including situations where
institutions have indirect exposure to an obligor or are holding a
previously sold position as collateral or as a reference asset in a
derivative.
Borrower/counterparty leveraged finance reporting
should consider exposures booked in other business units throughout
the institution, including indirect exposure such as default swaps
and total return swaps naming the distributed paper as a covered or
reference asset or collateral exposure through repo transactions.
Additionally, the institution should consider positions held in
available for sale or traded portfolios or through structured
investment vehicles owned or sponsored by the originating
institution or its subsidiaries or affiliates.

Risk Rating Leveraged Loans

The Agencies have previously issued guidance on rating credit
exposures and credit rating systems, which applies to all credit
transactions, including those in the leveraged lending category.\9\
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\9\ FRB SR 98-25 ``Sound Credit Risk Management and the Use of
Internal Credit Risk Ratings at Large Banking Organizations;'' OCC
Handbooks ``Rating Credit Risk'' and ``Leveraged Lending;'' FDIC
Risk Management Manual of Examination Policies, ``Loan Appraisal and
Classification.''
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Risk rating leveraged loans involves the use of realistic
repayment assumptions to determine the borrower's ability to de-
lever to a sustainable level within a reasonable period of time. If
the projected capacity to pay down debt from cash flow is nominal,
with refinancing the only viable option, the credit will usually be
criticized even if it has been recently underwritten. In cases where
leveraged loan transactions have no reasonable or realistic
prospects to de-lever, a substandard classification is likely.
Furthermore, when assessing debt service capacity, extensions and
restructures should be scrutinized to ensure that they are not
merely masking repayment capacity problems.
If the primary source of repayment becomes inadequate it would
generally be inappropriate to consider enterprise value as a
secondary source unless that value is well supported. Evidence of
well-supported value may include binding purchase and sale
agreements with qualified third parties or through valuations that
fully consider the effect of the borrower's distressed circumstances
and potential changes in business and market conditions. For such
borrowers, when a portion of the loan may not be protected by
pledged assets or a well-supported enterprise value, examiners
generally will rate that portion doubtful or loss and place the loan
on nonaccrual.

Other Key Risk Management Components

Credit Analysis

Effective underwriting and management of leveraged finance risk
is highly dependent on the quality of analysis employed during the
approval process as well as ongoing monitoring. Policies should
address the need for a comprehensive assessment of financial,
business, industry, and management risks including, but not limited
to, whether:
Cash flow analyses rely on overly optimistic or
unsubstantiated projections of sales, margins, and merger and
acquisition synergies.
Liquidity analyses include performance metrics
appropriate for the borrower's industry, predictability of the
borrower's cash flow, measurement of the borrower's operating cash
needs, and ability to meet debt maturities.
Projections exhibit an adequate margin for
unanticipated merger-related integration costs.
Projections are stress tested for several downside
scenarios, including a covenant breach.
Transactions are reviewed at least quarterly to
determine variance from plan, the risk implications thereof, and the
accuracy of risk ratings and accrual status. From inception, the
credit file should contain a chronological rationale for and
analysis of all substantive changes to the borrower's operating plan
and variance from expected financial performance.
Enterprise and collateral valuations are derived or
validated independently of the origination function, are timely, and
consider potential value erosion.
Collateral liquidation and asset sale estimates are
conservative.
Potential collateral shortfalls are identified and
factored into risk rating and accrual decisions.
Contingency plans anticipate changing conditions in
debt or equity markets when exposures rely on refinancing or the
issuance of new equity.
The borrower is adequately protected from interest rate
and foreign exchange risk.

Problem Credit Management

Financial institutions should formulate individual action plans
when working with borrowers that are experiencing diminished
operating cash flows, depreciated collateral values, or other
significant variance to plan. Weak initial underwriting of
transactions, coupled with poor structure and limited covenants, may
make problem credit discussions and eventual restructurings more
difficult for lenders as well as result in less favorable outcomes.
Institutions should formulate credit policies that define
expectations for the management of adversely rated and other high-
risk borrowers whose performance departs significantly from planned
cash flows, asset sales, collateral values, or other important
targets. These policies should stress the need for workout plans
that contain

[[Page 19424]]

quantifiable objectives and measureable time frames. Actions may
include working with the borrower for an orderly resolution while
preserving the institution's interests, sale of the credit in the
secondary market, or liquidation. Problem credits should be reviewed
regularly for risk rating accuracy, accrual status, recognition of
impairment through specific allocations, and charge-offs.

Deal Sponsors

Institutions should develop guidelines for evaluating the
qualifications of financial sponsors and implement a process to
regularly monitor performance. Deal sponsors may provide valuable
support to borrowers such as strategic planning, management, and
other tangible and intangible benefits. Sponsors may also provide a
source of financial support for a borrower that fails to achieve
projections. Institutions generally rate borrowers based on their
analysis of the borrowers' standalone financial condition. However,
lending institutions may consider support from a sponsor in
assigning an internal risk rating when the institution can document
the sponsor's history of demonstrated support as well as the
economic incentive, capacity, and stated intent to continue to
support the transaction. However, even with documented capacity and
a history of support, a sponsor's potential contributions may not
mitigate examiner criticism absent a documented commitment of
continued support. An evaluation of a sponsor's financial support
should include the following:
Sponsor's historical performance in supporting its
investments, financially and otherwise.
Sponsor's economic incentive to support, including the
nature and amount of capital contributed at inception.
Documentation of degree of support (e.g., guarantee,
comfort letter, verbal assurance).
Consideration of the sponsor's contractual investment
limitations.
To the extent feasible, a periodic review of the
sponsor's financial statements and trends, and an analysis of its
liquidity, including the ability to fund multiple deals.
Consideration of the sponsor's dividend and capital
contribution practices.
Likelihood of supporting the borrower compared to other
deals in the sponsor's portfolio.
Guidelines for evaluating the qualifications of
financial sponsors and a process to regularly monitor performance.

Credit Review

Institutions should have a strong and independent credit review
function with a demonstrated ability to identify portfolio risks and
documented authority to escalate inappropriate risks and other
findings to senior management. Due to the elevated risk inherent in
leveraged finance, and depending on the relative size of an
institution's leveraged finance business, it may be prudent for the
institution's credit review function to examine the leveraged
portfolio more frequently than other segments, go into greater
depth, and be more selective in identifying personnel to assess the
underlying transactions. Portfolio reviews should generally be
conducted at least annually. For many institutions, the risk
characteristics of the leveraged portfolio, such as high reliance on
enterprise value, concentrations, adverse risk rating trends, or
portfolio performance, may dictate more frequent reviews.
Institutions should staff their internal credit review function
appropriately and ensure that it has sufficient resources to ensure
timely, independent, and accurate assessments of leveraged finance
transactions. Reviews should evaluate the level of risk and risk
rating integrity, valuation methodologies, and the quality of risk
management. Internal credit reviews also should encompass a review
of the institution's leveraged finance practices, policies and
procedures to ensure that they are consistent with regulatory
guidance.

Conflicts of Interest

Institutions should develop appropriate policies to address and
prevent potential conflicts of interest. For example, a lender may
be reluctant to use an aggressive collection strategy with a problem
borrower because of the potential impact on the value of the
lender's equity interest. A lender may receive pressure to provide
financial or other privileged client information that could benefit
an affiliated equity investor. Such conflicts also may occur where
the underwriting bank serves as financial advisor to the seller and
simultaneously offers financing to multiple buyers (i.e., stapled
financing). Similarly, there may be conflicting interests between
the different lines of business or between the institution and its
affiliates. These and other situations may arise that create
conflicts of interest between the institution and its customers.
Policies should clearly define potential conflicts of interest,
identify appropriate risk management controls and procedures, enable
employees to report potential conflicts of interest to management
for action without fear of retribution, and ensure compliance with
applicable law. Further, management should establish responsibility
for training employees on how to avoid conflicts of interest, as
well as provide for reporting, tracking, and resolution of any
conflicts of interest that occur.

Anti-Tying Regulations

Because leveraged finance transactions often involve a number of
types of debt and several bank products, institutions should ensure
that their policies incorporate safeguards to prevent violations of
anti-tying regulations. Section 106(b) of the BHC Act Amendments of
1970 prohibits certain forms of product tying by banks and their
affiliates. The intent behind section 106(b) is to prevent
institutions from using their market power over certain products to
obtain an unfair competitive advantage in other products.

Reputational Risk

Leveraged finance transactions are often syndicated through the
bank and institutional markets. An institution's apparent failure to
meet its legal or fiduciary responsibilities in underwriting and
distributing transactions can damage its reputation and impair its
ability to compete. Similarly, institutions distributing
transactions that over time have significantly higher default or
loss rates and performance issues may also see their reputation
damaged in the markets.

Securities Laws

Equity interests and certain debt instruments used in leveraged
finance transactions may constitute ``securities'' for the purposes
of federal securities laws. When securities are involved,
institutions should ensure compliance with applicable securities
laws, including disclosure and other regulatory requirements.
Institutions should also establish procedures to appropriately
manage the internal dissemination of material nonpublic information
about transactions in which it plays a role.

Compliance Function

The legal and regulatory issues raised by leveraged transactions
are numerous and complex. To ensure that potential conflicts are
avoided and laws and regulations are adhered to, an independent
compliance function should periodically review an institution's
leveraged finance activity. Additional information is available in
the Agencies' existing guidance on compliance with laws and
regulations.

Conclusion

Leveraged finance is an important type of financing for the
economy, and the banking industry plays an integral role in making
credit available and syndicating that credit to investors.
Institutions should ensure they do not heighten risks by originating
poorly underwritten deals that find their way into a wide variety of
investment instruments. Therefore, it is important this financing be
provided to creditworthy borrowers in a safe and sound manner that
is consistent with this guidance.

Dated: March 19, 2012.
John Walsh,
Acting Comptroller of the Currency.

By order of the Board of Governors of the Federal Reserve
System, March 22, 2012.
Jennifer J. Johnson,
Secretary of the Board.
Dated at Washington, DC, this 26th Day of March 2012.

Federal Deposit Insurance Corporation.
Valerie J. Best,
Assistant Executive Secretary.
[FR Doc. 2012-7620 Filed 3-29-12; 8:45 am]
BILLING CODE 4810-33- 6210-01- 6714-01-P