Evaluate the adequacy of the leveraged lending policy and underwriting guidance. Policy or underwriting guidance should address the following matters:

• A definition of leveraged lending.

• Portfolio risk exposure limits.

• Risk exposure sublimits defining exposure by sponsor group, risk rating, and the levels of underwriting exposure and policy exceptions.

• Approval requirements that require sufficient senior level oversight.

• Pricing policies that ensure a prudent tradeoff between risk and return.

• A requirement for action plans whenever cash flow, asset sale proceeds, or collateral values decline significantly from projections. Action plans should include remedial initiatives and triggers for rating downgrades, changes to accrual status, and loss recognition.

• Appropriate loan structures.

• Amortization requirements of term loans.

• Collateral requirements including acceptable types of collateral, loan-to-value limits, collateral margins, and proper valuation methodologies.

• Covenant requirements, particularly minimum interest and fixed charge coverage and maximum leverage ratios.

• A description of how enterprise values and other intangible business values may be used.

• Minimum documentation requirements for appraisals and valuations, including enterprise values and other intangibles.

• The types of customers, financial sponsors, and industries that are acceptable.

• Acceptable types of financial statements and minimum standards for requiring, receiving, and analyzing financial data.

• Procedures for approving exceptions to policy and underwriting guidance and maintaining MIS to track those exceptions.

• Procedures and safeguards to address potential conflicts of interest. Institutions should identify and track totals for borrowers and sponsors to whom it has both a lending and equity relationship, and set appropriate limits for such relationships.

If the bank’s activities include syndication and loan participation activities, additional policy guidance should address these issues:

Syndications

• Procedures for defining, managing, and accounting for distribution fails.

• Identification of any sales made with recourse and procedures for fully reflecting the risk of any such sales.

• A process to ensure that purchasers and syndicate members are provided with timely, current financial information.

• A process to determine the portion of a transaction to be held in the portfolio, and the portion and acceptable timeframe to be held-for-sale.

• Limits on aggregate volume of bridge financing.

• Procedures and MIS to identify, control, and monitor syndication pipeline exposure.

• Limits on the length of time transactions can be held in the held-for-sale account and policies for handling items that exceed those limits.

• Prompt recognition of losses in market value for loans classified as held-for-sale.

• Procedural safeguards to prevent conflicts of interest for the bank and affiliated entities, including securities firms.

Loan Participations Purchased

• Obtaining and independently analyzing full credit information before the participation is purchased and on a timely basis thereafter.

• Obtaining from the lead lender copies of all executed and proposed loan documents, legal opinions, title insurance policies, UCC searches, and other relevant documents.

• Carefully monitoring the borrower’s performance throughout the life of the loan.

• Establishing appropriate risk management guidelines.

Determine whether the policy establishes concentration guidelines for leveraged lending and outlines actions to be taken when limits are exceeded.

Determine that annual reviews of leveraged lending policies and underwriting guidance are conducted by the board or an appropriate credit committee.

Evaluate how policies, procedures, and plans affecting the leveraged lending portfolio are communicated. Consider

• Whether management has clearly communicated objectives and risk limits for the leveraged lending portfolio to the board of directors and whether the board has approved these policies.

• Whether communication to key personnel in the leveraged lending department or to those loan officers involved in leveraged lending transactions is timely.

Determine whether management information systems provide timely, useful information to evaluate risk levels and trends in the leveraged lending portfolio.

Assess the process to ensure the accuracy and integrity of leveraged lending data.

Determine the effectiveness of processes to monitor compliance with leveraged lending policy. Consider

• Approval and monitoring of policy limit exceptions.

• The volume and type of exceptions including any identified in the loan sample.

• Internal loan review, audit, and compliance process findings.

Assess the underwriting process for leveraged loans. Consider the appropriateness of the approval process and the adequacy of credit analysis.

Evaluate the accuracy and integrity of the internal risk rating processes. Consider

• Findings from the loan sample.

• The role of loan review.

Assess the process to ensure compliance with applicable laws, rulings, regulations, and accounting guidelines.

Evaluate the effectiveness of processes used to monitor enterprise valuations. Consider the quality, frequency, and independence of the process.

The examiner reviewing the leveraged loan portfolio should review the LPM examiner’s findings to determine whether additional analysis is required for issues pertaining to

• Problem credit administration.

• Collections.

• Charge-offs.

In conjunction with the review of the Allowance for Loan and Lease Losses account, review the method of evaluating, documenting, and maintaining the account. Determine whether the method is consistent with current accounting and regulatory guidance.

Verify the integrity of loan documentation. Assess the quality controls ensuring that credit documentation is complete.

Assess the risk limits management has established, evaluating both portfolio-wide limits and less comprehensive ones. After determining how much earnings or capital is at risk, decide whether these limits are appropriate. Evaluate the plans management has developed to respond to breaches in defined risk tolerance levels.

Determine whether there are processes to monitor strategic and business plans for the portfolio. Consider the impact on earnings and capital as leveraged lending plans and strategies are executed.

Evaluate the adequacy of internal controls within the leveraged lending unit or function and the bank’s process to periodically evaluate its internal review procedures.

Assess the bank’s process to identify and safeguard against conflicts of interest.

Determine whether the level of expertise and number of assigned personnel in the designated leveraged lending area or function is adequate. Consider

• Whether staffing levels will support current operations or any planned growth.

• Staff turnover.

• The staff’s previous leveraged lending and workout experience.

• Specialized training provided.

• The average account load per lending officer. Consider whether the load is reasonable in light of the complexity and condition of each officer’s portfolio.

• How senior management and the board of directors periodically evaluate the leveraged lending unit’s understanding of and conformance with the bank’s stated credit culture and loan policy. If there is no evaluation, determine the impact on the management of credit risk.

Assess the performance management and compensation programs for leveraged lending personnel. Consider whether these programs measure and reward behaviors that support the portfolio’s strategic objectives and risk tolerance limits.

Assess the effectiveness and independence of formal control functions.

Control functions should have clear reporting lines, adequate resources, and the authority necessary to initiate change. Evaluate reporting lines to determine whether lenders could bring to bear undue influence on operations or control staff.

Determine the effectiveness of the loan review system in identifying risk in leveraged lending. Consider the following:

• Scope of loan review.

• Frequency of loan reviews.

• The number and qualifications of loan review personnel.

• Results of examination.

• Loan review’s access to information and the board.

• Training opportunities or programs offered to loan review staff.

• Content of loan review reports, which should address

  • The overall asset quality of the portfolio.

  • Trends in asset quality.

  • The quality of “significant” relationships.

  • The level and trend of policy, underwriting, and pricing exceptions

Review the most recent loan review report for the leveraged lending area. Determine whether management has appropriately addressed weaknesses and areas of unwarranted risk.

Assess loan review’s ability to identify emerging problems.

Determine whether problems have to be pronounced before loan review brings them to senior management’s attention.

Determine whether management information systems provide timely, useful information to evaluate risk levels and trends in the leveraged lending portfolio.

Determine the adequacy of internal audit functions for leveraged l ending. Consider:

• The scope of internal audit and results of the previous audit.

• Frequency of audits.

• The number and qualifications of internal audit personnel.

• Audit’s access to information and the board.

• Adequacy and timeliness of follow-up reviews.

Obtain from the examiner assigned internal and external audits a list of deficiencies noted in internal and external auditors’ latest reviews. Determine whether management has appropriately addressed these deficiencies.

Determine whether management’s response to any material findings by any control group (including audit and loan review) has been verified and reviewed for objectivity and adequacy by senior management and the board (or a committee thereof).