How Banks Can Navigate Loan Participation Sales
Loan participations have historically been a valuable tool for banks, because they can take part in transactions that would be too risky for them to do alone, and they can purchase or sell an interest in a transaction to meet their legal lending limit.
For the past five years, banks have been subject to accounting standards which govern the recording of loans and securing financial assets. Loan activity and related participation agreements declined significantly during the financial crisis, but as the economy has improved, so has lending activity.
Most banks have a general understanding of how accounting standards affect the sale treatment of loan participations sold — a standard that determines whether a transaction is a qualifying sale or if the bank has entered into a secured borrowing. However, many still have questions about how the rules relate to their situation, as oftentimes there are unique characteristics with individual loan transfers. Below are some issues that some of our banking clients have encountered when conducting loan sales.
Transfers that are “participating interests” qualify
In order to meet the standard’s criteria for sale accounting, a transfer must be a “participating interest”. The lead bank (i.e., the bank that oversees the loan) must evaluate whether the transfer meets four conditions:
- The transfer is structured so that there are proportionate ownership rights with equal priority to each participating interest holder (pro rata ownership for all parties involved).
- There is no recourse (other than standard representations and warranties) to, or subordination by, any participant.
- All cash flows from the loan are divided proportionately among the participants, excluding reasonable servicing fees. The servicing fees exclusion only applies if the fees are not subordinate to the proportionate cash flows and are not significantly higher than the amount necessary to fairly compensate the lead institution. Each participant (including the lead institution) must have the same priority, and no participant can have recourse to the lead institution.
- The entire financial asset can’t be pledged or exchanged unless all participants have agreed to do so.
If the transfer meets the conditions for participating interest, it must also meet the conditions for surrender of control.
Examples of when a “participation sold” does not qualify
If a participation sold does not meet the definition of a participating interest and the conditions for a transfer of control, both the lead bank transferring the participation and the bank purchasing it must consider the transaction as a secured borrowing and provide collateral. This may result in a liability, rather than reducing the amount of loans on the bank’s financial statements.
A participation sold would not meet the definition of participating interest when, for example, a “last in, first out” provision exists which lets one participant receive loan payments before another. This does not qualify because it allows a participating interest holder to receive disproportionate cash flows from the loan payments.
Another example that may impact qualification is when a participation agreement with a pass-through interest rate differs from the contract rate. Usually this difference exists to compensate the lead bank for servicing the loan.
Cash flows allocated as compensation for services (such as loan servicing fees) that amount to more than what a substitute service provider would receive can result in a disproportionate division of cash flows among the participating interest holders. Therefore, this would preclude the portion of a transferred financial asset from meeting the definition of a participating interest.
In these instances, the lead bank should carefully consider and document what is a reasonable amount of compensation and be prepared to justify this to regulators or examiners.
How to handle reclaiming or “buying back” transferred funds
As stated, one of the requirements for sale accounting is that the transferor must not maintain effective control over the transferred financial assets through a “unilateral ability to reclaim” the assets. The standard addresses specific arrangements, but many banks have requested further clarification about this issue.
One of the more frequent arrangements occurs when a customer’s borrowing needs exceeds its bank’s legal lending limits. The lead bank can accommodate the customer by transferring a portion of the customer’s loan to at least one participating bank. Oftentimes there is a “noncontractual understanding” among the participants, and the participating bank will return a portion of the loan at face value to the lead bank if the lead bank’s legal lending limit increases.
The standard does not consider a noncontractual understanding to meet the definition of a “unilateral ability to reclaim specific transferred assets,” because the lead bank is not in a position to do this. Although the participating bank may choose to comply with the lead bank’s request (and be motivated to do so by the prospect of future business dealings, for example) it is not contractually obligated to comply.
When entering into a participation agreement, banks should consider taking following action:
- Obtain a legal opinion if there is any doubt about whether the agreement is a qualifying sale.
- For significant agreements, or agreements that contain additional clauses or nonstandard terms, get an attorney’s true sale opinion.
- The lead bank can always negotiate a buy back of participated funds, but it is important to document the circumstances of each buy back. However, the seller’s subsequent behavior may cause original intent to be questioned. When intent is tainted by subsequent events and actions, regulators may apply that intent to other unrelated transfers of financial assets. For example, if a lead bank has a history of buying back participated funds, regulators may presume that the bank has the intent and ability to buy back all participations; resulting in a conclusion that agreements are in fact borrowings, and not qualifying sales.
- Selling and buying back before and after the reporting period ends may bring financial reporting practices into question by regulators.
How we can help
It is important for banks to evaluate each transfer carefully, because if a loan does not qualify for sale treatment under the standard it may impact its legal lending limits, risk management practices, and possibly capital ratios. Contact your financial advisor with questions about how loan participations may affect your bank.