Appeal of Material Supervisory Determinations (Second Quarter 2017)
A bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the conclusions from its most recent interim examination, communicated in a supervisory letter (SL), regarding the bank's exposure to Term Loan B (TLB) loans.
The appeal disagreed with the SO that TLB loans are inherently structurally weak with minimal amortization and few covenants, represent an unsafe and unsound banking practice, and are inappropriate if notable exposure exists.
The appeal contended TLB loans do not represent undue risk based solely on structure because the loans are senior secured with the facility being the only senior-secured term debt in many cases. The appeal further asserted that rating agencies do not differentiate the probability of default or loss-given-default metrics between the A and B tranches of senior-secured credit facilities because their security position is equal in priority.
The appeal stated TLB loans are appropriate for banks as they are subject to Shared National Credits examinations and the SO should permit the bank to purchase or originate such loans. The appeal also argued that the bank has a diversified leveraged lending portfolio across industries, and that concentration risk is significantly less than would be the case with a portfolio of commercial real estate loans concentrated in a single geographic market.
The Ombudsman conducted a comprehensive review of information based on the following supervisory standards:
- The following booklets of the Comptroller's Handbook:
- OCC Bulletin 2013-9, "Leveraged Lending: Guidance on Leveraged Lending," March 22, 2013
- OCC Bulletin 2014–55, "Leveraged Lending: Frequently Asked Questions for Implementing March 2013 Interagency Guidance on Leveraged Lending," November 7, 2014
- Banking Circular 181 (REV), "Purchase of Loans in Whole or in Part-Participations," August 2, 1984
The Ombudsman concurred with the bank that TLB loans are not unsafe and unsound solely due to the loans' structure. Further, there is no supervisory guidance that specifically identifies TLB loans as structurally weak. However, banks must recognize structural weaknesses in TLB loans. This includes weaknesses, such as minimal amortization and few or no maintenance covenants, that represent underwriting deficiencies that could compromise a bank's ability to control a credit relationship if economic or other events adversely affect the borrower. The Ombudsman also noted that TLB loans with second-lien exposure and borrowers with high leverage can represent undue risk if not properly managed, monitored, or controlled.
The Ombudsman rendered a split decision on the appropriateness of TLB loans for insured depository institutions. The Ombudsman determined that TLB loans are an appropriate investment for banks that possess the knowledge, expertise, and sound risk management controls and practices to mitigate and monitor the risks found in this type of lending. The Ombudsman concurred with the risk management deficiencies identified by the SO regarding the oversight of participations purchased and leveraged lending. The Ombudsman determined that the board and management must correct the risk management deficiencies, dedicate sufficient staff with appropriate expertise to oversee syndicated lending, and ensure capital levels and concentration risk limits are commensurate with the risk in the portfolio. The Ombudsman directed the SO to revise the SL to remove language that TLB loans are for nonbank entities and include language noted in this paragraph.
The Ombudsman determined that second-lien debt generally has a higher degree of risk than first-lien TLB structures, requiring bank management to conduct in-depth due diligence to ensure sufficient support for repayment of all debt. The bank must also monitor these exposures as a percent of capital plus the allowance for loan and lease losses (ALLL).
The Ombudsman agreed with the SO that the bank's concentration limit of 400 percent of tier 1 capital plus the ALLL is excessive. The concentration limit does not function as an effective risk management control as it significantly exceeds the bank's current and projected leveraged loan concentration levels. Furthermore, the SO identified concentration risk management deficiencies and noted weak quality of credit risk management, which do not support such a high concentration limit in high-risk loans. The Ombudsman determined that the board and management must reassess the leveraged lending concentration limit to ensure that it is an effective risk management control and that there is sufficient capital to support risk posed by a large portfolio of highly leveraged borrowers with minimal loan controls.
The Ombudsman concurred with the SO that the bank's existing leveraged lending concentration is an inappropriate level of risk given the risk management deficiencies identified by the SO. Even if the loans are prudently underwritten and management has strong risk selection criteria, loan pools with similar characteristics can be negatively impacted by the same economic or financial factors. In addition, a high concentration of TLB loans requires consideration of the effect of multiple structural weaknesses in a large loan portfolio on the bank's credit risk profile, the ALLL, earnings, and capital during an economic or industry downturn. Further, the general structure of TLB loans typically does not include financial maintenance covenants requiring the borrower to maintain certain financial performance metrics. Without financial maintenance covenants, the bank may not be able to easily renegotiate the terms of pricing of a TLB loan with the borrower, if the borrower's leverage or cash flow deteriorates. The bank may lack negotiating power to refinance or amend the facility. These are important considerations when determining appropriate concentrations and therefore require close monitoring of TLB loan exposures as a percentage of capital. Given that a change in economic conditions or market forces can affect a significant portion of the bank's portfolio, the Ombudsman determined that a high concentration in leveraged loans requires robust risk management practices, a diversified leveraged loan portfolio, sustainable earnings, strong capital levels, and robust stress testing. The OCC expects banks to have capital commensurate with the risk of the loan portfolio.