Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
exercise control of its ownership interest, a purchasing
bank must ascertain that the selling bank will provide
complete and timely credit information on a continuing
basis.
The procedures for purchasing loan participations should
be provided for in the bank's formal lending policy. The
criteria for participation loans should be consistent with
that for similar direct loans. The policy would normally
require the complete analysis of the credit quality of
obligations to be purchased, determination of value and
lien status of collateral, and the maintenance of full credit
information for the life of the participation.
Participation Agreements - A participation loan can
present unique problems if the borrower defaults, the lead
bank becomes insolvent, or a party to the participation
arrangement does not perform as expected. These
contingencies should be considered in a written
participation agreement. The agreement should clearly
state the limitations the originating and participating banks
impose on each other and the rights all parties retain. In
addition to the general terms of the participation
transaction, participation agreements should specifically
include the following considerations:
• The obligation of the lead bank to furnish timely credit
information and to provide notification of material
changes in the borrower's status;
• Requirements that the lead bank consult with
participants prior to modifying any loan, guaranty, or
security agreements and before taking any action on
defaulted loans;
• The specific rights and remedies available to the lead
and participating banks upon default of the borrower;
• Resolution procedures when the lead and participating
banks cannot agree on the handling of a defaulted
loan;
• Resolution of any potential conflicts between the lead
bank and participants in the event that more than one
loan to the borrower defaults; and
• Provisions for terminating the agency relationship
between the lead and participating banks upon such
events as insolvency, breach of duty, negligence, or
misappropriation by one of the parties.
In some loan participation agreements, the participation
agreement provides for the allocation of loan payments on
some basis other than in proportion to ownership interest.
For example, principal payments may be applied first to
the participant’s ownership interest and all remaining
payments to the lead bank’s ownership interest. In these
instances, the participation agreement must also specify
that in case of loan default, participants will share in all
subsequent payments and collections in proportion to their
respective ownership interest at the time of default.
Without such a provision, the banks would not have a prorata
sharing of credit risk. Provided the sales criteria
contained in FAS 140 are met, loan participations sold in
which the participation agreements provide for the
allocation of loan payments, absent default, on some basis
other than proportional ownership interests, may be treated
as sold and removed from the balance sheet for financial
reporting purposes. However, if the participation
agreements do not also contain a provision requiring that
all payments and collections received subsequent to default
be allocated based on ownership interests in the loan as of
the date of default, those participations will be treated as
loans sold with recourse for risk-based capital purposes
regardless of the financial reporting treatment. Further
discussion of loans sold with recourse is contained in the
Sales of Assets for Risk-Based Capital Purposes entry in
the glossary of the Call Report Instructions.
Participations Between Affiliated Institutions -
Examiners should ascertain that banks do not relax their
credit standards when dealing with affiliated institutions
and that participation loans between affiliated institutions
are in compliance with Section 23A of the Federal Reserve
Act. The Federal Reserve Board Staff has interpreted that
the purchase of a participation loan from an affiliate is
exempt from Section 23A provided that the commitment to
purchase is obtained by the affiliate before the loan is
consummated by the affiliate, and the decision to
participate is based upon the bank's independent evaluation
of the creditworthiness of the loan. If these criteria are not
strictly met, the loan participation could be subject to the
qualitative and/or quantitative restrictions of Section 23A.
Refer to the Related Organizations Section of this Manual
which describes transactions with affiliates.
Sales of 100 Percent Loan Participations - In some
cases, depository institutions structure loan originations
and participations with the intention of selling off 100
percent of the underlying loan amount. Certain 100
percent loan participation programs raise unique safety and
soundness issues that should be addressed by an
institution’s policies, procedures and practices.
If not appropriately structured, these 100 percent
participation programs can present unwarranted risks to the
originating institution including legal, reputation and
compliance risks. While this statement applies only to a
small number of mostly very large insured depository
institutions, the agreements should clearly state the
limitations the originating and participating institutions
impose on each other and the rights all parties retain. The
originating institution should state that loan participants are
participating in loans and are not investing in a business
DSC Risk Management Manual of Examination Policies 3.2-35 Loans (12-04)
Federal Deposit Insurance Corporation