Leveraged Lending and Shared National Credit (SNC) Recent Issues

The following is the next installment in RMA’s Credit Risk Council 2016 Industry Insights: Perspectives from the Front Line.

It’s been three years since the OCC, FRB, and the FDIC issued guidance on leveraged lending and banks have therefore now experienced exams and feedback from respective regulators on this topic. There continues to be intense focus and attention on leveraged lending in exams and in other regulatory commentary. While we could debate the actual thresholds set from a senior and a total debt perspective, we can all agree that companies with higher leverage are more at risk in a weaker economy than companies with less leverage.

Proper identification of leveraged loans at inception, including appropriate enterprise valuation and continued portfolio tracking of leveraged loans, is critical. Establishing limits for the total leverage portfolio either as a percentage of the total portfolio or Tier I capital is a best practice. Post mortems on credits that have migrated to criticized or classified status, and whether they were leveraged at inception, are a good tool to reassess the appropriateness of higher leverage in certain industries. Finally, a review of the bank’s industry exclusions, which are allowable under the regulation to ensure that an industry with higher leverage continues to perform as would be expected, is prudent.

Recent SNC exams and feedback have placed great emphasis on the energy sector and, therefore, energy-related SNCs (and leveraged loans). Sound underwriting practices, frequent monitoring and the ability to understand the impact of oil and gas prices (i.e., sensitivity analysis) on the upstream portfolio is important—it allows a thorough analysis of projected cash flows both best and worst case. While to date midstream portfolios seem unaffected, it is reasonable to assume that an extended duration of low oil and gas prices will impact midstream companies. Oil field service companies already feel the impact.

Related to the concerns about energy is the contagion effect on those regions and markets economically linked to the energy industry. Both consumer and commercial real estate portfolios in these areas are particular to note and should be closely monitored for any signs of negative trends. HVCRE regulation continues to instill discipline in structure by requiring cash equity to stay in transactions through construction. It remains to be seen whether it is enough to help offset the negative impacts of the energy sector at this time.

In general, continued close monitoring of CRE portfolios remains a priority. Maintaining reasonable CRE portfolio concentrations as a percentage of the total book will help minimize the impact of increased provisions due to CRE credits moving to the watch list. Establishing concentration limits for both property type and geography are a best practice. In summary, being proactive both in origination practices from a portfolio diversification perspective and ongoing monitoring should prove positive for the credit quality of the total portfolio over time.

Please look for next week's Industry Insight, Small Business Lending Outlook.

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