Notification of Engaging in Crypto-Related Activities

LOANS

Section 3.2

RMS Manual of Examination Policies

3.2-1

Loans (05/23)

Federal Deposit Insurance Corporation

INTRODUCTION.............................................................. 3

LOAN ADMINISTRATION ............................................. 3

Lending Policies ............................................................. 3

Loan Review Systems .................................................... 4

Credit Risk Rating or Grading Systems ..................... 4

Loan Review System Elements .................................. 5

Current Expected Credit Losses (CECL) ....................... 6

Allowance for Loan and Lease Losses (ALLL) ............. 6

Responsibility of the Board and Management ........... 7

Factors to Consider in Estimating Credit Losses........ 7

Examiner Responsibilities .......................................... 8

Regulatory Reporting of the ALLL ............................ 8

Accounting and Reporting Treatment ........................ 8

PORTFOLIO COMPOSITION .......................................... 9

Commercial Loans ......................................................... 9

General ....................................................................... 9

Accounts Receivable Financing ................................... 10

Leveraged Lending ....................................................... 10

Applicability ............................................................. 11

General ..................................................................... 11

Risk Management Framework ................................. 11

General Policies ....................................................... 12

Participations Purchased .......................................... 12

Underwriting Standards............................................ 12

Credit Analysis ......................................................... 13

Valuation Standards ................................................. 13

Risk Rating Leveraged Loans .................................

....................................... 12

Participations Purchased .......................................... 12

Underwriting Standards............................................ 12

Credit Analysis ......................................................... 13

Valuation Standards ................................................. 13

Risk Rating Leveraged Loans .................................. 14

Problem Credit Management.................................... 14

Reporting and Analytics ........................................... 14

Deal Sponsors........................................................... 15

Independent Credit Review ...................................... 16

Stress Testing ........................................................... 16

Conflicts of Interest .................................................. 16

Oil and Gas Lending .................................................... 16

Industry Overview .................................................... 16

Reserve-Based Lending ............................................ 17

Real Estate Loans ......................................................... 21

General ..................................................................... 21

Real Estate Lending Standards ................................. 22

Commercial Real Estate Loans ................................ 23

Real Estate Construction Loans ............................... 23

Home Equity Loans ...................................................... 25

Agricultural Loans ....................................................... 26

Introduction .............................................................. 26

Agricultural Loan Types and Maturities .................. 26

Agricultural Loan Underwriting Guidelines ............ 27

Administration of Agricultural Loans ...................... 28

Classification Guidelines for Agricultural Credit ..... 29

Installment Loans ........................................................

Introduction .............................................................. 26

Agricultural Loan Types and Maturities .................. 26

Agricultural Loan Underwriting Guidelines ............ 27

Administration of Agricultural Loans ...................... 28

Classification Guidelines for Agricultural Credit ..... 29

Installment Loans ......................................................... 30

Lease Accounting ......................................................... 31

Direct Lease Financing............................................. 31

Lessor Accounting under ASC Topic 840................ 31

Lessor Accounting under ASC Topic 842................ 31

Examiner Consideration ........................................... 32

Floor Plan Loans .......................................................... 32

Check Credit and Credit Card Loans ........................... 32

Credit Card-related Merchant Activities ...................... 33

OTHER CREDIT ISSUES .............................................. 34

Appraisals .................................................................... 34

Valuation of Troubled Income-Producing Properties

................................................................................. 34

Appraisal Regulation ............................................... 35

Interagency Appraisal and Evaluation Guidelines ... 36

Examination Treatment ........................................... 41

Loan Participations ...................................................... 41

Accounting .............................................................. 41

Right to Repurchase ................................................. 42

Recourse Arrangements ........................................... 42

Call Report Treatment ............................................. 42

Independent Credit Analysis .................................... 43

Participation Agreements ......................................... 43

Participations Between Affiliated Institutions ........

purchase ................................................. 42

Recourse Arrangements ........................................... 42

Call Report Treatment ............................................. 42

Independent Credit Analysis .................................... 43

Participation Agreements ......................................... 43

Participations Between Affiliated Institutions ......... 43

Sales of 100 Percent Loan Participations................. 43

Environmental Risk Program ...................................... 44

Elements of an Effective Environmental Risk

Program ................................................................... 44

Examination Procedures .......................................... 46

LOAN PROBLEMS ........................................................ 46

Poor Selection of Risks ................................................ 46

Overlending ................................................................. 47

Failure to Establish or Enforce Liquidation Agreements

..................................................................................... 47

Incomplete Credit Information .................................... 47

Overemphasis on Loan Income ................................... 47

Self-Dealing ................................................................. 47

Technical Incompetence .............................................. 47

Lack of Supervision ..................................................... 47

Lack of Attention to Changing Economic Conditions . 48

Competition ................................................................. 48

Potential Problem Indicators by Document ................. 48

SELECTING A LOAN REVIEW SAMPLE IN A RISK-

FOCUSED EXAMINATION .......................................... 49

Assessing the Risk Profile ........................................... 49

Selecting the Sample ................................................... 49

Nonhomogeneous Loan Sample .............................

............... 48

Potential Problem Indicators by Document ................. 48

SELECTING A LOAN REVIEW SAMPLE IN A RISK-

FOCUSED EXAMINATION .......................................... 49

Assessing the Risk Profile ........................................... 49

Selecting the Sample ................................................... 49

Nonhomogeneous Loan Sample .............................. 49

Homogeneous Pool Sample ..................................... 50

Determining the Depth of the Review ......................... 50

Adjusting Loan Review ............................................... 51

Accepting an Institution’s Internal Ratings ................. 51

Loan Penetration Ratio ................................................ 51

Large Bank Loan Review ............................................ 51

LOAN EVALUATION AND CLASSIFICATION ........ 51

Loan Evaluation ........................................................... 51

Review of Files and Records ....................................... 51

Additional Transaction Testing ............................... 52

Loan Discussion .......................................................... 52

Loan Analysis .............................................................. 52

Loan Classification ...................................................... 53

Definitions ................................................................... 53

Special Mention Assets................................................ 54

Troubled Commercial Real Estate Loan Classification

Guidelines .................................................................... 54

..................... 52

Loan Classification ...................................................... 53

Definitions ................................................................... 53

Special Mention Assets................................................ 54

Troubled Commercial Real Estate Loan Classification

Guidelines .................................................................... 54

LOANS

Section 3.2

Loans (05/23)

3.2-2

RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

Technical Exceptions ................................................... 55

Past Due and Nonaccrual ............................................. 55

Nonaccrual Loans That Have Demonstrated Sustained

Contractual Performance .............................................. 56

Troubled Debt Restructuring - Multiple Note Structure

...................................................................................... 56

Interagency Retail Credit Classification Policy............ 56

Re-aging, Extensions, Deferrals, Renewals, or

Rewrites ................................................................... 57

Partial Payments on Open-End and Closed-End

Credit ........................................................................ 58

Examination Considerations .................................... 58

Examination Treatment ............................................ 58

Impaired Loans, Troubled Debt Restructurings,

Foreclosures, and Repossessions .................................. 59

Report of Examination Treatment of Classified Loans 61

Issuance of "Express Determination" Letters to

Institutions for Federal Income Tax Purposes .............. 62

CONCENTRATIONS ...................................................... 63

FEDERAL FUNDS SOLD AND REPURCHASE

AGREEMENTS ............................................................... 64

Assessing Bank-to-Bank Credit ..............................

ation Treatment of Classified Loans 61

Issuance of "Express Determination" Letters to

Institutions for Federal Income Tax Purposes .............. 62

CONCENTRATIONS ...................................................... 63

FEDERAL FUNDS SOLD AND REPURCHASE

AGREEMENTS ............................................................... 64

Assessing Bank-to-Bank Credit ............................... 65

FUNDAMENTAL LEGAL CONCEPTS AND

DEFINITIONS ................................................................. 65

Uniform Commercial Code – Secured Transactions .... 65

General Provisions ................................................... 66

Grant of Security Interest ......................................... 66

Collateral .................................................................. 66

Perfecting the Security Interest ................................ 66

Right to Possess and Dispose of Collateral .............. 66

Agricultural Liens .................................................... 67

Borrowing Authorization ............................................. 68

Bond and Stock Powers................................................ 68

Co-maker ...................................................................... 68

Loan Guarantee ............................................................ 68

Subordination Agreement ............................................ 69

Hypothecation Agreement ............................................ 69

Real Estate Mortgage ................................................... 69

Collateral Assignment .................................................. 70

CONSIDERATION OF BANKRUPTCY LAW AS IT

RELATES TO COLLECTIBILITY OF A DEBT ........... 70

Introduction .................................................................. 70

Forms of Bankruptcy Relief ......................................... 70

Functions of Bankruptcy Trustees ................................ 71

Voluntary and Involuntary Bankruptcy .......................

................. 70

CONSIDERATION OF BANKRUPTCY LAW AS IT

RELATES TO COLLECTIBILITY OF A DEBT ........... 70

Introduction .................................................................. 70

Forms of Bankruptcy Relief ......................................... 70

Functions of Bankruptcy Trustees ................................ 71

Voluntary and Involuntary Bankruptcy ........................ 71

Automatic Stay ............................................................. 71

Property of the Estate ................................................... 71

Discharge and Objections to Discharge ....................... 71

Reaffirmation ............................................................... 72

Classes of Creditors ...................................................... 72

Preferences ................................................................... 72

Setoffs .......................................................................... 72

Transfers Not Timely Perfected or Recorded ............... 73

SYNDICATED LENDING.............................................. 73

Overview ...................................................................... 73

Syndication Process ..................................................... 73

Loan Covenants ........................................................... 74

Credit Rating Agencies ................................................ 74

Overview of the Shared National Credit (SNC) Program

..................................................................................... 74

Definition of a SNC ................................................. 75

SNC Review and Rating Process ............................. 75

SNC Rating Communication and Distribution Process

................................................................................. 75

Appeals Process ....................................................... 75

Additional Risks Associated with Syndicated Loan

Participations ..............................................................

Review and Rating Process ............................. 75

SNC Rating Communication and Distribution Process

................................................................................. 75

Appeals Process ....................................................... 75

Additional Risks Associated with Syndicated Loan

Participations ............................................................... 76

CREDIT SCORING ........................................................ 76

SUBPRIME LENDING .................................................. 77

Introduction ................................................................. 77

Capitalization ............................................................... 78

Stress Testing ............................................................... 79

Risk Management ........................................................ 79

Classification ............................................................... 82

ALLL Analysis ............................................................ 82

Subprime Auto Lending .............................................. 82

Subprime Residential Real Estate Lending.................. 83

Subprime Credit Card Lending .................................... 83

Payday Lending ........................................................... 83

General .................................................................... 84

Underwriting ............................................................ 84

Payday Lending Through Third Parties ................... 84

Concentrations ......................................................... 85

Capital Adequacy .................................................... 85

Allowance for Loan and Lease Losses .................... 85

Classifications .......................................................... 86

Renewals/Rewrites .................................................. 86

Accrued Fees and Finance Charges ......................... 86

Recovery Practices .................................................

................................................... 85

Allowance for Loan and Lease Losses .................... 85

Classifications .......................................................... 86

Renewals/Rewrites .................................................. 86

Accrued Fees and Finance Charges ......................... 86

Recovery Practices .................................................. 86

LOANS

Section 3.2

RMS Manual of Examination Policies

3.2-3

Loans (05/23)

Federal Deposit Insurance Corporation

INTRODUCTION

Section 39 of the Federal Deposit Insurance Act, Standards

for Safety and Soundness, requires each federal banking

agency to establish safety and soundness standards for all

insured depository institutions. Appendix A to Part 364 of

the FDIC Rules and Regulations, Interagency Guidelines

Establishing Standards for Safety and Soundness, sets out

the safety and soundness standards that the agencies use to

identify and address problems at insured depository

institutions before capital becomes impaired. Operational

and managerial safety and soundness standards pertaining

to an institution’s loan portfolio address areas such as asset

quality, internal controls, credit underwriting, and loan

documentation.

The examiner’s evaluation of an institution’s lending

policies, credit administration, and the quality of the loan

portfolio is among the most important aspects of the

examination process. To a great extent, the quality of an

institution's loan portfolio determines the risk to depositors

and to the FDIC's insurance fund. Conclusions regarding

the institution’s condition and the quality of its management

are weighted heavily by the examiner's findings with regard

to lending practices

uality of the loan

portfolio is among the most important aspects of the

examination process. To a great extent, the quality of an

institution's loan portfolio determines the risk to depositors

and to the FDIC's insurance fund. Conclusions regarding

the institution’s condition and the quality of its management

are weighted heavily by the examiner's findings with regard

to lending practices. Emphasis on review and evaluation of

the loan portfolio and its administration by institution

management during examinations recognizes that loans

comprise a major portion of most institutions’ assets; and,

that it is the asset category which ordinarily presents the

greatest credit risk and potential loss exposure to banks.

Moreover, pressure for increased profitability, liquidity

considerations, and a more complex society produce great

innovations in credit instruments and approaches to lending.

Loans

have

consequently

become

more

complex.

Examiners therefore find it necessary to devote a large

portion of time and attention to loan portfolio examination.

←

LOAN ADMINISTRATION

Lending Policies

The examiner's evaluation of the loan portfolio involves

much more than merely appraising individual loans.

Prudent management and administration of the overall loan

account, including establishment of sound lending and

collection policies, are of vital importance if the institution

is to be continuously operated in an acceptable manner.

Lending policies should be clearly defined and set forth in

such a manner as to provide effective supervision by the

directors and senior officers. The board of directors of

every institution is responsible for formulating lending

policies and to supervise their implementation. Therefore

examiners

should

encourage

establishment

and

maintenance of written, up-to-date lending policies which

have been approved by the board of directors

t forth in

such a manner as to provide effective supervision by the

directors and senior officers. The board of directors of

every institution is responsible for formulating lending

policies and to supervise their implementation. Therefore

examiners

should

encourage

establishment

and

maintenance of written, up-to-date lending policies which

have been approved by the board of directors. A lending

policy should not be a static document, but must be

reviewed periodically and revised in light of changing

circumstances surrounding the borrowing needs of the

institution's customers as well as changes that may occur

within the institution itself. To a large extent, the economy

of the community served by the institution dictates the

composition of the loan portfolio. The widely divergent

circumstances of regional economies and the considerable

variance in characteristics of individual loans preclude

establishment of standard or universal lending policies.

There are, however, certain broad areas of consideration and

concern that are typically addressed in the lending policies

of all banks regardless of size or location. These include the

following:

•

General fields of lending in which the institution will

engage and the kinds or types of loans within each

general field;

•

Lending authority of each loan officer;

•

Lending authority of a loan or executive committee, if

any;

•

Responsibility of the board of directors in reviewing,

ratifying, or approving loans;

•

Guidelines under which unsecured loans will be

granted;

•

Guidelines for rates of interest and the terms of

repayment for secured and unsecured loans;

•

Limitations on the amount advanced in relation to the

value of the collateral and the documentation required

by the institution for each type of secured loan;

•

Guidelines for obtaining and reviewing real estate

appraisals as well as for ordering reappraisals, when

needed;

•

Maintenance and review of complete and current

credit files on each borrower;

•

Appropriate collection procedu

ured loans;

•

Limitations on the amount advanced in relation to the

value of the collateral and the documentation required

by the institution for each type of secured loan;

•

Guidelines for obtaining and reviewing real estate

appraisals as well as for ordering reappraisals, when

needed;

•

Maintenance and review of complete and current

credit files on each borrower;

•

Appropriate collection procedures including, but not

limited to, actions to be taken against borrowers who

fail to make timely payments;

•

Limitations on the maximum volume of loans in

relation to total assets;

•

Limitations on the extension of credit through

overdrafts;

•

Description of the institution's normal trade area and

circumstances under which the institution may extend

credit outside of such area;

•

Guidelines that address the goals for portfolio mix and

risk diversification and cover the institution's plans for

monitoring and taking appropriate corrective action, if

deemed necessary, on any concentrations that may

exist;

•

Guidelines addressing the institution's loan review and

grading system ("Watch list");

LOANS

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3.2-4

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Federal Deposit Insurance Corporation

•

Guidelines addressing the institution's review of the

Allowance for Loan and Lease Losses (ALLL) or

ACL for loans and leases, as appropriate; and

•

Guidelines for adequate safeguards to minimize

potential environmental liability.

Note: The allowance for credit losses on loans and leases

or ACL for loans and leases is the term used for those banks

that adopted ASU 2016-13, which implements ASC Topic

326, Financial Instruments – Credit Losses replacing the

allowance for loan losses used under the incurred loss

methodology.

The above are only guidelines for areas that should be

considered during the loan policy evaluation. Examiners

should also encourage management to develop specific

guidelines for each lending department or function

that adopted ASU 2016-13, which implements ASC Topic

326, Financial Instruments – Credit Losses replacing the

allowance for loan losses used under the incurred loss

methodology.

The above are only guidelines for areas that should be

considered during the loan policy evaluation. Examiners

should also encourage management to develop specific

guidelines for each lending department or function. As with

overall lending policies, it is not the FDIC's intent to suggest

universal or standard loan policies for specific types of

credit. The establishment of these policies is the

responsibility of each institution's Board and management.

Therefore, the following discussion of basic principles

applicable to various types of credit will not include or

allude to acceptable ratios, levels, comparisons or terms.

These matters should, however, be addressed in each

institution's lending policy, and it will be the examiner's

responsibility to determine whether the policies are realistic

and being followed.

Much of the rest of this section of the Manual discusses

areas that should be considered in the institution's lending

policies. Guidelines for their consideration are discussed

under the appropriate areas.

Loan Review Systems

The terms loan review system or credit risk review system

refer to the responsibilities assigned to various areas such as

credit underwriting, loan administration, problem loan

workout, or other areas. Responsibilities may include

assigning initial credit grades, ensuring grade changes are

made when needed, or compiling information necessary to

assess the appropriateness of the ALLL or ACL for loans

and leases.

The complexity and scope of a loan review system will vary

based upon an institution’s size, type of operations, and

management practices. Systems may include components

that are independent of the lending function, or may place

some reliance on loan officers

es are

made when needed, or compiling information necessary to

assess the appropriateness of the ALLL or ACL for loans

and leases.

The complexity and scope of a loan review system will vary

based upon an institution’s size, type of operations, and

management practices. Systems may include components

that are independent of the lending function, or may place

some reliance on loan officers. Although smaller

institutions are not expected to maintain separate loan

review departments, it is essential that all institutions have

an effective loan review system. Regardless of its

complexity, an effective loan review system is generally

designed to address the following objectives:

•

To promptly identify loans with well-defined credit

weaknesses so that timely action can be taken to

minimize credit loss;

•

To provide essential information for determining the

appropriateness of the ALLL or ACL for loans and

leases;

•

To identify relevant trends affecting the collectibility

of the loan portfolio and isolate potential problem

areas;

•

To evaluate the activities of lending personnel;

•

To assess the adequacy of, and adherence to, loan

policies and procedures, and to monitor compliance

with relevant laws and regulations;

•

To provide the board of directors and senior

management with an objective assessment of the

overall portfolio quality; and

•

To provide management with information related to

credit quality that can be used for financial and

regulatory reporting purposes.

Credit Risk Rating or Grading Systems

Accurate and timely credit grading is a primary component

of an effective loan review system. Credit grading involves

an assessment of credit quality, the identification of problem

loans, and the assignment of risk ratings. An effective

system provides information for use in establishing an

allowance when evaluating specific credits and for the

determination of an overall ALLL or ACL for loans and

leases, as appropriate

ng is a primary component

of an effective loan review system. Credit grading involves

an assessment of credit quality, the identification of problem

loans, and the assignment of risk ratings. An effective

system provides information for use in establishing an

allowance when evaluating specific credits and for the

determination of an overall ALLL or ACL for loans and

leases, as appropriate.

Credit grading systems often place primary reliance on loan

officers for identifying emerging credit problems.

However, given the importance and subjective nature of

credit grading, a loan officer’s judgement regarding the

assignment of a particular credit grade should generally be

subject to review. Reviews may be performed by peers,

superiors, loan committee(s), or other internal or external

credit review specialists. Credit grading reviews performed

by individuals independent of the lending function are

preferred because they can often provide a more objective

assessment of credit quality. A loan review system typically

includes the following:

•

A formal credit grading system that can be reconciled

with the framework used by federal regulatory

agencies;

•

An identification of loans or loan pools that warrant

special attention;

•

A mechanism for reporting identified loans, and any

corrective action taken, to senior management and the

board of directors; and

•

Documentation of an institution’s credit loss

experience for various components of the loan and

lease portfolio.

that can be reconciled

with the framework used by federal regulatory

agencies;

•

An identification of loans or loan pools that warrant

special attention;

•

A mechanism for reporting identified loans, and any

corrective action taken, to senior management and the

board of directors; and

•

Documentation of an institution’s credit loss

experience for various components of the loan and

lease portfolio.

LOANS

Section 3.2

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3.2-5

Loans (05/23)

Federal Deposit Insurance Corporation

Loan Review System Elements

Loan review policies are typically reviewed and approved

at least annually by the board of directors. Policy guidelines

include a written description of the overall credit grading

process, and establish responsibilities for the various loan

review functions. The policy generally addresses the

following items:

•

Qualifications of loan review personnel;

•

Independence of loan review personnel;

•

Frequency of reviews;

•

Scope of reviews;

•

Depth of reviews;

•

Review of findings and follow-up; and

•

Workpaper and report distribution.

Qualifications of Loan Review Personnel

Personnel to involve in the loan review function are

qualified based on level of education, experience, and extent

of formal training. They are knowledgeable of both sound

lending practices and their own institution’s specific lending

guidelines. In addition, they are knowledgeable of pertinent

laws and regulations that affect lending activities.

Loan Review Personnel Independence

Loan officers are generally responsible for ongoing credit

analysis and the prompt identification of emerging

problems. Because of their frequent contact with

borrowers, loan officers can usually identify potential

problems before they become apparent to others. However,

institutions should be careful to avoid over reliance upon

loan officers

ctivities.

Loan Review Personnel Independence

Loan officers are generally responsible for ongoing credit

analysis and the prompt identification of emerging

problems. Because of their frequent contact with

borrowers, loan officers can usually identify potential

problems before they become apparent to others. However,

institutions should be careful to avoid over reliance upon

loan officers. To avoid conflicts of interest, management

typically ensures that, when feasible, all significant loans

are reviewed by individuals that are not part of, or

influenced by anyone associated with, the loan approval

process.

Larger institutions typically establish separate loan review

departments staffed by independent credit analysts. Cost

and volume considerations may not justify such a system in

smaller institutions. Often, members of senior management

that are independent of the credit administration process, a

committee of outside directors, or an outside loan review

consultant fill this role. Regardless of the method used, loan

review personnel should report their findings directly to the

board of directors or a board committee.

Frequency of Reviews

The loan review function provides feedback on the

effectiveness of the lending process in identifying emerging

problems. Reviews of significant credits are generally

performed annually, upon renewal, or more frequently when

factors indicate a potential for deteriorating credit quality.

A system of periodic reviews is particularly important to the

process of determining the ALLL or the ACL for loans and

leases, as appropriate.

Scope of Reviews

Reviews typically cover all loans that are considered

significant. In addition to loans over a predetermined size,

management will normally review smaller loans that present

elevated risk characteristics such as credits that are

delinquent, on nonaccrual status, restructured as a troubled

debt, previously classified, or designated as Special

Mention

eases, as appropriate.

Scope of Reviews

Reviews typically cover all loans that are considered

significant. In addition to loans over a predetermined size,

management will normally review smaller loans that present

elevated risk characteristics such as credits that are

delinquent, on nonaccrual status, restructured as a troubled

debt, previously classified, or designated as Special

Mention. Additionally, management may wish to

periodically review insider loans, recently renewed credits,

or loans affected by common repayment factors. The

percentage of the portfolio selected for review should

provide reasonable assurance that all major credit risks have

been identified.

Depth of Reviews

Loan reviews typically analyze a number of important credit

factors, including:

•

Credit quality;

•

Sufficiency of credit and collateral documentation;

•

Proper lien perfection;

•

Proper loan approval;

•

Adherence to loan covenants;

•

Compliance with internal policies and procedures, and

applicable laws and regulations; and

•

The accuracy and timeliness of credit grades assigned

by loan officers.

Review of Findings and Follow-up

Loan review findings should be reviewed with appropriate

loan officers, department managers, and members of senior

management. Typically, any existing or planned corrective

action (including estimated timeframes) is obtained for all

noted deficiencies, with those deficiencies that remain

unresolved reported to senior management and the board of

directors.

Workpaper and Report Distribution

A list of the loans reviewed, including the review date, and

documentation supporting assigned ratings is commonly

prepared. A report that summarizes the results of the review

is typically submitted to the board at least quarterly.

Findings usually address adherence to internal policies and

procedures, and applicable laws and regulations, so that

rectors.

Workpaper and Report Distribution

A list of the loans reviewed, including the review date, and

documentation supporting assigned ratings is commonly

prepared. A report that summarizes the results of the review

is typically submitted to the board at least quarterly.

Findings usually address adherence to internal policies and

procedures, and applicable laws and regulations, so that

LOANS

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Federal Deposit Insurance Corporation

deficiencies can be remedied in a timely manner.

Examiners should review the written response from

management in response to any substantive criticisms or

recommendations and assess corrective actions taken.

Current Expected Credit Losses (CECL)

The Current Expected Credit Losses (CECL) methodology

as implemented by FASB Accounting Standards

Codification (ASC) Subtopic 326-20, Financial Instruments

– Credit Losses – Measured at Amortized Cost applies to

financial assets measured at amortized cost, net investments

in

leases,

and

off-balance-sheet

credit

exposures

(collectively, financial assets). For institutions that are SEC

filers, excluding those that are “smaller reporting

companies” as defined in the SEC’s rules, the CECL

methodology is effective for fiscal years beginning January

1, 2020, for institutions with calendar year fiscal years. For

all other institutions, (i.e., non-public institutions),

including those SEC filers that are smaller reporting

companies, CECL will take effect for institutions with

calendar year fiscal years beginning after December 15,

2022, (i.e., January 1, 2023).

The CECL methodology does not apply to financial assets

measured at fair value through net income, including those

assets for which the fair value option has been elected; loans

held-for-sale; policy loan receivables of an insurance entity;

loans and receivables between entities under common

control; and receivables arising from operating leases

ter December 15,

2022, (i.e., January 1, 2023).

The CECL methodology does not apply to financial assets

measured at fair value through net income, including those

assets for which the fair value option has been elected; loans

held-for-sale; policy loan receivables of an insurance entity;

loans and receivables between entities under common

control; and receivables arising from operating leases.

Available-for-sale debt securities are not covered under the

CECL methodology but are covered by ASC Subtopic 326-

30, Financial Instruments – Credit Losses – Available-for-

Sale Debt Securities for institutions that have adopted ASC

Topic 326.

The allowance for credit losses or ACL for loans and leases

is a valuation account that is deducted from, or added to, the

amortized cost basis of financial assets to present the net

amount expected to be collected over the contractual term

of the assets, considering expected prepayments. Renewals,

extensions, and modifications are excluded from the

contractual term of a financial asset for purposes of

estimating the ACL for loans and leases unless there is a

reasonable expectation of executing a troubled debt

restructuring or the renewal and extension options are part

of the original or modified contract and are not

unconditionally cancellable by the institution.

In estimating the net amount expected to be collected,

management should consider the effects of past events,

current conditions, and reasonable and supportable forecasts

on the collectibility of the institution’s financial assets.

Under the CECL methodology, inputs will need to change

in order to achieve an appropriate estimate of expected

credit losses. For example, inputs to a loss rate method

would need to reflect expected losses over the contractual

term, rather than the annual loss rates commonly used under

the existing incurred loss methodology. To properly apply

an acceptable estimation method, an institution’s credit loss

estimates must be well supported

change

in order to achieve an appropriate estimate of expected

credit losses. For example, inputs to a loss rate method

would need to reflect expected losses over the contractual

term, rather than the annual loss rates commonly used under

the existing incurred loss methodology. To properly apply

an acceptable estimation method, an institution’s credit loss

estimates must be well supported.

Similar to the ALLL, the ACL for loans and leases is

evaluated as of the end of each reporting period and reported

in the Consolidated Reports of Condition and Income (Call

Report). The methods used to determine ACLs generally

should be applied consistently over time and reflect

management’s current expectations of credit losses.

Changes to ACL for loans and leases resulting from these

periodic evaluations are recorded through increases or

decreases to the related provisions for credit losses (PCLs).

Throughout this Section 3.2, Loans, references pertaining

to the ALLL describe the incurred methodology and apply

only to institutions that have not yet adopted ASC Topic 326.

As such, the methodology for impairment contained in ASC

Subtopic 310-10, Receivables - Overall and collective loan

impairment

contained

in

ASC

Subtopic

450-20,

Contingencies – Loss Contingencies has been superseded

and is not applicable for institutions that have adopted ASC

Topic 326 (CECL). Therefore, for those institutions that

have adopted CECL, examiners should refer to the Call

Report Glossary entry for “allowance for credit losses” and

the, “Interagency Policy Statement on Credit Losses,”

issued May 8, 2020, via FIL 54-2020, for additional

information on the CECL methodology.

Allowance for Loan and Lease Losses (ALLL)

Each institution must maintain an ALLL that is appropriate

to absorb estimated credit losses associated with the held for

investment loan and lease portfolio, i.e., loans and leases

that the institution has the intent and ability to hold for the

foreseeable future or until maturity or payoff

020, for additional

information on the CECL methodology.

Allowance for Loan and Lease Losses (ALLL)

Each institution must maintain an ALLL that is appropriate

to absorb estimated credit losses associated with the held for

investment loan and lease portfolio, i.e., loans and leases

that the institution has the intent and ability to hold for the

foreseeable future or until maturity or payoff. Each

institution should also maintain, as a separate liability

account, an allowance sufficient to absorb estimated credit

losses associated with off-balance sheet credit instruments

such as loan commitments, standby letters of credit, and

guarantees. This separate liability account for estimated

credit losses on off-balance sheet credit exposures should

not be reported as part of the ALLL on an institution’s

balance sheet. Loans and leases held for sale are carried on

the balance sheet at the lower of cost or fair value, with a

separate valuation allowance. This separate valuation

allowance should not be included as part of the ALLL and

accordingly regulatory capital.

The term "estimated credit losses" means an estimate of the

current amount of the loan and lease portfolio (net of

unearned income) that is not likely to be collected; that is,

net charge-offs that are likely to be realized for a loan, or

pool of loans. The estimated credit losses should meet the

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criteria for accrual of a loss contingency (i.e., a provision to

the ALLL) set forth in generally accepted accounting

principles (U.S. GAAP). When available information

confirms specific loans and leases, or portions thereof, to be

uncollectible, these amounts should be promptly charged-

off against the ALLL.

Estimated credit losses should reflect consideration of all

significant factors that affect repayment as of the evaluation

date

e., a provision to

the ALLL) set forth in generally accepted accounting

principles (U.S. GAAP). When available information

confirms specific loans and leases, or portions thereof, to be

uncollectible, these amounts should be promptly charged-

off against the ALLL.

Estimated credit losses should reflect consideration of all

significant factors that affect repayment as of the evaluation

date. Estimated losses on loan pools should reflect

historical net charge-off levels for similar loans, adjusted for

changes in current conditions or other relevant factors.

Calculation of historical charge-off rates can range from a

simple average of net charge-offs over a relevant period, to

more complex techniques, such as migration analysis.

Portions of the ALLL can be attributed to, or based upon the

risks associated with, individual loans or groups of loans.

However, the ALLL is available to absorb credit losses that

arise from the entire portfolio. It is not segregated for any

particular loan, or group of loans.

Responsibility of the Board and Management

It is the responsibility of the board of directors and

management to maintain the ALLL at an appropriate level.

The allowance should be evaluated, and appropriate

provisions made, at least quarterly. In carrying out their

responsibilities, the board and management are expected to:

•

Establish and maintain a loan review system that

identifies, monitors, and addresses asset quality

problems in a timely manner.

•

Ensure the prompt charge-off of loans, or portions of

loans, deemed uncollectible.

•

Ensure that the process for determining an appropriate

allowance level is based on comprehensive,

adequately documented, and consistently applied

analysis

management are expected to:

•

Establish and maintain a loan review system that

identifies, monitors, and addresses asset quality

problems in a timely manner.

•

Ensure the prompt charge-off of loans, or portions of

loans, deemed uncollectible.

•

Ensure that the process for determining an appropriate

allowance level is based on comprehensive,

adequately documented, and consistently applied

analysis.

For purposes of Reports of Condition and Income (Call

Reports) an appropriate ALLL for loans held for investment

should consist of the following items:

•

The amount of allowance related to loans individually

evaluated and determined to be impaired under ASC

(Accounting Standards Codification) Subtopic 310-10,

Receivables - Overall.

•

The amount of allowance related to loans that were

individually evaluated for impairment and determined

not to be impaired, as well as other loans collectively

evaluated under ASC Subtopic 450-20, Contingencies

– Loss Contingencies.

•

The amount of allowance related to loans evaluated

under ASC Subtopic 310-30, Receivables –Loans and

Debt Securities Acquired with Deteriorated Credit

Quality.

•

The amount of allowance related to international

transfer risk associated with its cross-border lending

exposure.

Furthermore, management’s analysis of an appropriate

allowance

level

requires

significant

judgement

in

determining estimates of credit losses. An institution may

support its estimate through qualitative factors that adjust

historical loss rates or an unallocated portion that can be

supported through a similar analysis.

When determining an appropriate allowance, primary

reliance should normally be placed on analysis of the

various components of a portfolio, including all significant

credits reviewed on an individual basis. Examiners should

refer to ASC Subtopic 310-10 for guidance in establishing

an allowance for individually evaluated loans determined to

be impaired and measured under that standard

ysis.

When determining an appropriate allowance, primary

reliance should normally be placed on analysis of the

various components of a portfolio, including all significant

credits reviewed on an individual basis. Examiners should

refer to ASC Subtopic 310-10 for guidance in establishing

an allowance for individually evaluated loans determined to

be impaired and measured under that standard. When

analyzing the appropriateness of an allowance, portfolios

evaluated collectively should group loans with similar

characteristics, such as risk classification, past due status,

type of loan, industry, or collateral. A depository institution

may, for example, analyze the following groups of loans and

provide for them in the ALLL:

•

Significant credits reviewed on an individual basis

(i.e., impaired loans);

•

Loans and leases that are not reviewed individually,

but which present elevated risk characteristics, such as

delinquency, adverse classification, or Special

Mention designation;

•

Homogenous loans that are not reviewed individually,

and do not present elevated risk characteristics; and

•

All other loans that have not been considered or

provided for elsewhere.

In addition to estimated credit losses, the losses that arise

from the transfer risk associated with an institution’s cross-

border lending activities require special consideration.

Over and above any minimum amount that is required by

the Interagency Country Exposure Review Committee to be

provided in the Allocated Transfer Reserve (or charged to

the ALLL), an institution must determine if their ALLL is

appropriate to absorb estimated losses from transfer risk

associated with its cross-border lending exposure.

Factors to Consider in Estimating Credit Losses

Estimated credit losses should reflect consideration of all

significant factors that affect the portfolio’s collectibility as

of the evaluation date

ansfer Reserve (or charged to

the ALLL), an institution must determine if their ALLL is

appropriate to absorb estimated losses from transfer risk

associated with its cross-border lending exposure.

Factors to Consider in Estimating Credit Losses

Estimated credit losses should reflect consideration of all

significant factors that affect the portfolio’s collectibility as

of the evaluation date. While historical loss experience

provides a reasonable starting point, historical losses, or

even recent trends in losses, are not by themselves, a

sufficient basis to determine an appropriate ALLL level.

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Management should also consider any relevant qualitative

factors that are likely to cause estimated losses to differ from

historical loss experience such as:

•

Changes in lending policies and procedures, including

underwriting, collection, charge-off and recovery

practices;

•

Changes in local and national economic and business

conditions;

•

Changes in the volume or type of credit extended;

•

Changes in the experience, ability, and depth of

lending management;

•

Changes in the volume and severity of past due,

nonaccrual, troubled debt restructurings, or classified

loans;

•

Changes in the quality of an institution’s loan review

system or the degree of oversight by the board of

directors; and

•

The existence of, or changes in the level of, any

concentrations of credit.

Institutions are also encouraged to use ratio analysis as a

supplemental

check

for

evaluating

the

overall

reasonableness of an ALLL. Ratio analysis can be useful in

identifying trends in the relationship of the ALLL to

classified and nonclassified credits, to past due and

nonaccrual loans, to total loans and leases and binding

commitments, and to historical charge-off levels

of credit.

Institutions are also encouraged to use ratio analysis as a

supplemental

check

for

evaluating

the

overall

reasonableness of an ALLL. Ratio analysis can be useful in

identifying trends in the relationship of the ALLL to

classified and nonclassified credits, to past due and

nonaccrual loans, to total loans and leases and binding

commitments, and to historical charge-off levels. However,

while such comparisons can be helpful as a supplemental

check of the reasonableness of management’s assumptions

and analysis, they are not, by themselves, a sufficient basis

for determining an appropriate ALLL. Such comparisons

do not eliminate the need for a comprehensive analysis and

documentation of the loan and lease portfolio and the factors

affecting its collectibility.

Examiner Responsibilities

Generally, following the quality assessment of the loan and

lease portfolio, the loan review system, and the lending

policies, examiners are responsible for assessing the

appropriateness of the ALLL. Examiners should consider

all significant factors that affect the collectibility of the

portfolio. Examination procedures for reviewing the

appropriateness of the ALLL are included in the

Examination Documentation (ED) Modules.

In assessing the overall appropriateness of an ALLL, it is

important

to

recognize

that

the

related

process,

methodology, and underlying assumptions require a

substantial degree of judgement. Credit loss estimates will

not be precise due to the wide range of factors that must be

considered. Furthermore, the ability to estimate credit

losses on specific loans and categories of loans should

improve over time

l appropriateness of an ALLL, it is

important

to

recognize

that

the

related

process,

methodology, and underlying assumptions require a

substantial degree of judgement. Credit loss estimates will

not be precise due to the wide range of factors that must be

considered. Furthermore, the ability to estimate credit

losses on specific loans and categories of loans should

improve over time. Therefore, examiners will generally

accept management’s estimates of credit losses in their

assessment of the overall appropriateness of the ALLL

when management has:

•

Maintained effective systems and controls for

identifying, monitoring and addressing asset quality

problems in a timely manner;

•

Analyzed all significant factors that affect the

collectibility of the portfolio; and

•

Established an acceptable ALLL evaluation process

that meets the objectives for an appropriate ALLL.

If, after the completion of all aspects of the ALLL review

described in this section, the examiner does not concur that

the reported ALLL level is appropriate, or the ALLL

evaluation process is deficient, recommendations for

correcting these problems, including any examiner concerns

regarding an appropriate level for the ALLL, should be

noted in the Report of Examination.

Regulatory Reporting of the ALLL

An ALLL established in accordance with the guidelines

provided above should fall within a range of acceptable

estimates. When an ALLL is not deemed at an appropriate

level, management will be required to increase the provision

for loan and lease loss expense sufficiently to restore the

ALLL reported in its Call Report to an appropriate level.

Accounting and Reporting Treatment

ASC Subtopic 450-20 provides the basic guidance for

recognition of a loss from a contingency that should be

accrued through a charge to income (i.e., a provision

expense) when available information indicates that it is

probable the asset has been impaired and the amount is

reasonably estimated

the

ALLL reported in its Call Report to an appropriate level.

Accounting and Reporting Treatment

ASC Subtopic 450-20 provides the basic guidance for

recognition of a loss from a contingency that should be

accrued through a charge to income (i.e., a provision

expense) when available information indicates that it is

probable the asset has been impaired and the amount is

reasonably estimated. ASC Subtopic 310-10 provides

specific guidance about the measurement and disclosure for

loans individually evaluated and determined to be impaired.

Loans are considered to be impaired when, based on current

information and events, it is probable that the creditor will

be unable to collect all interest and principal payments due

according to the contractual terms of the loan agreement.

This would generally include all loans restructured as a

troubled debt and nonaccrual loans.

For individually impaired loans, ASC Subtopic 310-10

provides guidance on the acceptable methods to measure

impairment. Specifically, this standard states that when a

loan is impaired, a creditor should measure impairment

based on the present value of expected future cash flows

discounted at the loan’s effective interest rate, except that as

a practical expedient, a creditor may measure impairment

based on a loan’s observable market price. However, the

Call Report instructions require an institution to use the fair

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value of the collateral in its determination of impairment for

all impaired collateral dependent loans. When developing

the estimate of expected future cash flows for a loan, an

institution should consider all available information

reflecting past events and current conditions, including the

effect of existing qualitative factors.

Large groups of smaller-balance homogenous loans are not

included in the scope of ASC Subtopic 310-10, unless the

loan is a troubled debt restructuring

dent loans. When developing

the estimate of expected future cash flows for a loan, an

institution should consider all available information

reflecting past events and current conditions, including the

effect of existing qualitative factors.

Large groups of smaller-balance homogenous loans are not

included in the scope of ASC Subtopic 310-10, unless the

loan is a troubled debt restructuring. Such groups of loans

may include, but are not limited to, credit card, residential

mortgage, and consumer installment loans. Examiners

should refer to ASC Subtopic 450-20 for loans collectively

evaluated for impairment, as well as individual loans that

are identified for evaluation on an individual basis and

determined not to be impaired.

Institutions should not layer their loan loss allowances.

Layering is the inappropriate practice of recording estimates

in the ALLL for the same loan under the different

accounting standards. Layering can happen when an

institution measures impairment on an individually

impaired loan and includes that same loan in its estimate of

loan losses on a collective basis, thereby estimating the loan

loss for the same loan twice.

While different institutions may use different methods,

there are certain common elements that should be included

in any ALLL methodology. Generally, an institution’s

methodology should:

•

Include a detailed loan portfolio analysis, performed

regularly;

•

Consider all loans (whether on an individual or group

basis);

•

Identify loans to be evaluated for impairment on an

individual basis under ASC Subtopic 310-10; loans

evaluated under ASC Subtopic 310-30; and segment

the remainder of the portfolio into groups of loans

with similar risk characteristics for evaluation and

analysis under ASC Subtopic 450-20;

•

Consider all known relevant internal and external

factors that may affect loan collectibility;

•

Be applied consistently but, when appropriate, be

modified for new factors affecting collectibility;

•

Consider the particular risks inherent in d

; and segment

the remainder of the portfolio into groups of loans

with similar risk characteristics for evaluation and

analysis under ASC Subtopic 450-20;

•

Consider all known relevant internal and external

factors that may affect loan collectibility;

•

Be applied consistently but, when appropriate, be

modified for new factors affecting collectibility;

•

Consider the particular risks inherent in different

kinds of lending;

•

Consider current collateral values (less costs to sell),

where applicable;

•

Require that analyses, estimates, reviews and other

ALLL methodology functions be performed by

competent and well-trained personnel;

•

Be based on current and reliable data;

•

Be well-documented, in writing, with clear

explanations of the supporting analyses and rationale;

and

•

Include a systematic and logical method to consolidate

the loss estimates and ensure the ALLL balance is

recorded in accordance with U.S. GAAP.

A systematic methodology that is properly designed and

implemented should result in an institution’s best estimate

of the ALLL. Accordingly, institutions should adjust their

ALLL balance, either upward or downward, in each period

for differences between the results of the systematic

determination process and the unadjusted ALLL balance in

the general ledger.

Examiners are encouraged, with the acknowledgement of

management, to communicate with an institution’s external

auditors and request an explanation of their rationale and

findings, when differences in judgment concerning the

appropriateness of the institution's ALLL exist. In case of

controversy, an institution and its auditor may be reminded

when an institution's supervisory agency's interpretation on

how U.S

ged, with the acknowledgement of

management, to communicate with an institution’s external

auditors and request an explanation of their rationale and

findings, when differences in judgment concerning the

appropriateness of the institution's ALLL exist. In case of

controversy, an institution and its auditor may be reminded

when an institution's supervisory agency's interpretation on

how U.S. GAAP should be applied to a specified event or

transaction (or series of related events or transactions)

differs from the institution's interpretation, the supervisory

agency may require the institution to reflect the event(s) or

transaction(s) in its Call Report in accordance with the

agency's interpretation and to amend previously submitted

reports.

Additional information on the documentation of the ALLL,

including its methodology, and the establishment of loan

review systems is provided in the Interagency Statement of

Policy on the Allowance for Loan and Lease Losses,

(including frequently asked questions) dated December 13,

2006, and the Interagency Policy Statement on Allowance

for

Loan

and

Lease

Losses

Methodologies

and

Documentation for Banks and Savings Associations, dated

July 2, 2001.

←

PORTFOLIO COMPOSITION

Commercial Loans

General

Loans to business enterprises for commercial or industrial

purposes,

whether

proprietorships,

partnerships

or

corporations, are commonly described as commercial loans.

In asset distribution, commercial or business loans

frequently comprise one of the most important assets of an

institution. They may be secured or unsecured and have

short or long-term maturities. Such loans include working

to business enterprises for commercial or industrial

purposes,

whether

proprietorships,

partnerships

or

corporations, are commonly described as commercial loans.

In asset distribution, commercial or business loans

frequently comprise one of the most important assets of an

institution. They may be secured or unsecured and have

short or long-term maturities. Such loans include working

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capital advances, term loans and loans to individuals for

business purposes.

Short-term working capital and seasonal loans provide

temporary capital in excess of normal needs. They are used

to finance seasonal requirements and are repaid at the end

of the cycle by converting inventory and accounts

receivable into cash. Such loans may be unsecured;

however, many working capital loans are advanced with

accounts receivable and/or inventory as collateral. Firms

engaged in manufacturing, distribution, retailing and

service-oriented businesses use short-term working capital

loans.

Term business loans have assumed increasing importance.

Such loans normally are granted for the purpose of

acquiring capital assets, such as plant and equipment. Term

loans may involve a greater risk than do short-term

advances, because of the length of time the credit is

outstanding. Because of the potential for greater risk, term

loans are usually secured and generally require regular

amortization. Loan agreements on such credits may contain

restrictive covenants during the life of the loan. In some

instances, term loans may be used as a means of liquidating,

over a period of time, the accumulated and unpaid balance

of credits originally advanced for seasonal needs. While

such loans may reflect a borrower's past operational

problems, they may well prove to be the most viable means

of salvaging a problem situation and effecting orderly debt

collection

ing the life of the loan. In some

instances, term loans may be used as a means of liquidating,

over a period of time, the accumulated and unpaid balance

of credits originally advanced for seasonal needs. While

such loans may reflect a borrower's past operational

problems, they may well prove to be the most viable means

of salvaging a problem situation and effecting orderly debt

collection.

Commercial lending policies generally address acquisition

of credit information, such as property, operating and cash

flow statements; factors that might determine the need for

collateral acquisition; acceptable collateral margins;

perfecting liens on collateral; lending terms, and charge-

offs.

Accounts Receivable Financing

Accounts receivable financing is a specialized area of

commercial lending in which borrowers assign their

interests in accounts receivable to the lender as collateral.

Typical characteristics of accounts receivable borrowers are

those businesses that are growing rapidly and need

year-round financing in amounts too large to justify

unsecured credit, those that are nonseasonal and need

year-round financing because working capital and profits

are insufficient to permit periodic cleanups, those whose

working capital is inadequate for the volume of sales and

type of operation, and those whose previous unsecured

borrowings are no longer warranted because of various

credit factors.

Several advantages of accounts receivable financing from

the borrower's viewpoint are: it is an efficient way to

finance an expanding operation because borrowing capacity

expands as sales increase; it permits the borrower to take

advantage of purchase discounts because the company

receives immediate cash on its sales and is able to pay trade

creditors on a satisfactory basis; it insures a revolving,

expanding line of credit; and actual interest paid may be no

more than that for a fixed amount unsecured loan

ce an expanding operation because borrowing capacity

expands as sales increase; it permits the borrower to take

advantage of purchase discounts because the company

receives immediate cash on its sales and is able to pay trade

creditors on a satisfactory basis; it insures a revolving,

expanding line of credit; and actual interest paid may be no

more than that for a fixed amount unsecured loan.

Advantages from the institution's viewpoint are: it generates

a relatively high yield loan, new business, and a depository

relationship; permits continuing banking relationships with

long-standing customers whose financial conditions no

longer warrant unsecured credit; and minimizes potential

loss when the loan is geared to a percentage of the accounts

receivable collateral. Although accounts receivable loans

are collateralized, it is important to analyze the borrower's

financial statements. Even if the collateral is of good quality

and in excess of the loan, the borrower must demonstrate

financial progress. Full repayment through collateral

liquidation is normally a solution of last resort.

Institutions use two basic methods to make accounts

receivable advances. First, blanket assignment, wherein the

borrower periodically informs the institution of the amount

of receivables outstanding on its books. Based on this

information, the institution advances the agreed percentage

of the outstanding receivables. The receivables are usually

pledged on a non-notification basis and payments on

receivables are made directly to the borrower who then

remits them to the institution. The institution applies all or

a portion of such funds to the borrower's loan. Second,

ledgering the accounts, wherein the lender receives

duplicate copies of the invoices together with the shipping

documents and/or delivery receipts. Upon receipt of

satisfactory information, the institution advances the agreed

percentage of the outstanding receivables. The receivables

are usually pledged on a notification basis

ll or

a portion of such funds to the borrower's loan. Second,

ledgering the accounts, wherein the lender receives

duplicate copies of the invoices together with the shipping

documents and/or delivery receipts. Upon receipt of

satisfactory information, the institution advances the agreed

percentage of the outstanding receivables. The receivables

are usually pledged on a notification basis. Under this

method, the institution maintains complete control of the

funds paid on all accounts pledged by requiring the

borrower's customer to remit directly to the institution.

In the area of accounts receivable financing, an institution's

lending policy typically addresses the acquisition of credit

information such as property, operating and cash flow

statements. It also typically addresses maintenance of an

accounts receivable loan agreement that establishes a

percentage advance against acceptable receivables, a

maximum dollar amount due from any one account debtor,

financial strength of debtor accounts, insurance that

"acceptable receivables" are defined in light of the turnover

of receivables pledged, aging of accounts receivable, and

concentrations of debtor accounts.

Leveraged Lending

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The federal institution regulatory agencies initially issued

guidance on April 9, 2001, concerning sound risk

management practices for institutions engaged in leveraged

financing. In light of the developments and experience

gained since the initial guidance was issued, the federal

institution regulatory agencies issued new Interagency

Guidance on Leveraged Lending on May 21, 2013, to

update and replace the 2001 guidance. Examiners should

also review the related Frequently Asked Questions (FAQ)

issued on November 7, 2014

institutions engaged in leveraged

financing. In light of the developments and experience

gained since the initial guidance was issued, the federal

institution regulatory agencies issued new Interagency

Guidance on Leveraged Lending on May 21, 2013, to

update and replace the 2001 guidance. Examiners should

also review the related Frequently Asked Questions (FAQ)

issued on November 7, 2014.

Applicability

A financial institution’s risk management practices should

be consistent with the size and risk profile of its leveraged

activities relative to its assets, earnings, liquidity, and

capital. Institutions that originate or sponsor leveraged

transactions can refer to the guidance for suggestions about

sound risk management principles.

The agencies do not intend for a financial institution that

originates a small number of less complex, leveraged loans

to have policies and procedures commensurate with a larger,

more complex leveraged loan origination business.

However, any financial institution that participates in

leveraged lending transactions may refer to and consider

supervisory guidance provided in the “Participations

Purchased” section of the guidance.

General

Leveraged lending is an important type of financing for

national and global economies, and the U.S. financial

industry plays an integral role in making credit available and

syndicating that credit to investors. In particular, financial

institutions should ensure they do not unnecessarily

heighten risks by originating poorly underwritten loans. For

example, a poorly underwritten leveraged loan that is

pooled with other loans or is participated with other

institutions may generate risks for the financial system.

Numerous definitions of leveraged lending exist throughout

the financial services industry and commonly contain some

combination of the following:

•

Proceeds used for buyouts, acquisitions, or capital

distributions

oans. For

example, a poorly underwritten leveraged loan that is

pooled with other loans or is participated with other

institutions may generate risks for the financial system.

Numerous definitions of leveraged lending exist throughout

the financial services industry and commonly contain some

combination of the following:

•

Proceeds used for buyouts, acquisitions, or capital

distributions.

•

Transactions where the borrower’s Total Debt divided

by EBITDA (earnings before interest, taxes,

depreciation, and amortization) or Senior Debt divided

by EBITDA exceed 4.0X EBITDA or 3.0X EBITDA,

respectively, or other defined levels appropriate to the

industry or sector.

•

A borrower recognized in the debt markets as a highly

leveraged firm, which is characterized by a high debt-

to-net-worth ratio.

•

Transactions when the borrower’s post-financing

leverage, as measured by its leverage ratios (for

example, debt-to-assets, debt-to-net-worth, debt-to-

cash flow, or other similar standards common to

particular industries or sectors), significantly exceeds

industry norms or historical levels.

A financial institution engaging in leveraged lending

typically defines the activity within its policies and

procedures in a manner sufficiently detailed to ensure

consistent application across all business lines. An

appropriate definition describes clearly the purposes and

financial characteristics common to these transactions, and

covers risk from both direct exposure and indirect exposure

via limited recourse financing secured by leveraged loans,

or financing extended to financial intermediaries (such as

conduits and special purpose entities (SPEs)) that hold

leveraged loans.

In general, sound risk management of leveraged lending

activities places importance on institutions developing and

maintaining the following:

•

Transactions structured to reflect a sound business

premise, an appropriate capital structure, and

reasonable cash flow and balance sheet leverage

ancial intermediaries (such as

conduits and special purpose entities (SPEs)) that hold

leveraged loans.

In general, sound risk management of leveraged lending

activities places importance on institutions developing and

maintaining the following:

•

Transactions structured to reflect a sound business

premise, an appropriate capital structure, and

reasonable cash flow and balance sheet leverage.

Combined with supportable performance projections,

these elements of a safe-and-sound loan structure

should clearly support a borrower’s capacity to repay

and to de-lever to a sustainable level over a reasonable

period, whether underwritten to hold or distribute;

•

A definition of leveraged lending that facilitates

consistent application across all business lines;

•

Well-defined underwriting standards that, among

other things, define acceptable leverage levels and

describe amortization expectations for senior and

subordinate debt;

•

A credit limit and concentration framework consistent

with the institution’s risk appetite;

•

Sound Management Information Systems (MIS) that

enable management to identify, aggregate, and

monitor leveraged exposures and comply with policy

across all business lines;

•

Strong pipeline management policies and procedures

that, among other things, provide for real-time

information on exposures and limits, and exceptions to

the timing of expected distributions and approved hold

levels; and

•

Guidelines for conducting periodic portfolio and

pipeline stress tests to quantify the potential impact of

economic and market conditions on the institution’s

asset quality, earnings, liquidity, and capital.

Risk Management Framework

among other things, provide for real-time

information on exposures and limits, and exceptions to

the timing of expected distributions and approved hold

levels; and

•

Guidelines for conducting periodic portfolio and

pipeline stress tests to quantify the potential impact of

economic and market conditions on the institution’s

asset quality, earnings, liquidity, and capital.

Risk Management Framework

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Given the high-risk profile of leveraged transactions,

prudent financial institutions engaged in leveraged lending

adopt a risk management framework that has an intensive

and frequent review and monitoring process. The

framework has as its foundation written risk objectives, risk

acceptance criteria, and risk controls. A lack of robust risk

management processes and controls at a financial institution

with significant leveraged lending activities could

contribute to supervisory findings that the financial

institution is engaged in unsafe-and-unsound banking

practices.

General Policies

A financial institution’s credit policies and procedures for

leveraged lending generally address the following:

•

Identification of the financial institution’s risk appetite

including clearly defined amounts of leveraged

lending that the institution is willing to underwrite (for

example, pipeline limits) and is willing to retain (for

example, transaction and aggregate hold levels). The

designated risk appetite is commonly supported by an

analysis of the potential effect on earnings, capital,

liquidity, and other risks that result from these

positions, and is approved by the board of directors;

•

A limit framework that includes limits or guidelines

for single obligors and transactions, aggregate hold

portfolio, aggregate pipeline exposure, and industry

and geographic concentrations. This limit framework

identifies the related management approval authorities

and exception tracking provisions

ity, and other risks that result from these

positions, and is approved by the board of directors;

•

A limit framework that includes limits or guidelines

for single obligors and transactions, aggregate hold

portfolio, aggregate pipeline exposure, and industry

and geographic concentrations. This limit framework

identifies the related management approval authorities

and exception tracking provisions. In addition to

notional pipeline limits, financial institutions with

significant leveraged transactions implement

underwriting limit frameworks that assess stress

losses, flex terms, economic capital usage, and

earnings at risk or that otherwise provide a more

nuanced view of potential risk;

•

Procedures for ensuring the risks of leveraged lending

activities are appropriately reflected in an institution’s

allowance for loan and lease losses (ALLL) and

capital adequacy analyses;

•

Credit and underwriting approval authorities,

including the procedures for approving and

documenting changes to approved transaction

structures and terms;

•

Guidelines for appropriate oversight by senior

management, including adequate and timely reporting

to the board of directors;

•

Expected risk-adjusted returns for leveraged

transactions;

•

Minimum underwriting standards (see “Underwriting

Standards” section below); and,

•

Effective underwriting practices for primary loan

origination and secondary loan acquisition.

Participations Purchased

Well-managed

financial

institutions

purchasing

participations and assignments in leveraged lending

transactions make a thorough, independent evaluation of the

transaction and the risks involved before committing any

funds. They should apply the same standards of prudence,

credit assessment and approval criteria, and in-house limits

that would be employed if the purchasing organization were

originating the loan

institutions

purchasing

participations and assignments in leveraged lending

transactions make a thorough, independent evaluation of the

transaction and the risks involved before committing any

funds. They should apply the same standards of prudence,

credit assessment and approval criteria, and in-house limits

that would be employed if the purchasing organization were

originating the loan. Policies typically include requirements

for:

•

Obtaining and independently analyzing full credit

information both 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, Uniform Commercial Code (UCC)

searches, and other relevant documents;

•

Carefully monitoring the borrower’s performance

throughout the life of the loan; and

•

Establishing appropriate risk management guidelines

as described in this document.

Underwriting Standards

A financial institution’s underwriting standards should be

clear, written and measurable, and should accurately reflect

the institution’s risk appetite for leveraged lending

transactions. Examiners should review whether a financial

institution has clear underwriting limits regarding leveraged

transactions, including the size that the institution will

arrange both individually and in the aggregate for

distribution. Legal and other risks associated with poorly

underwritten transactions may find their way into a wide

variety of investment instruments and exacerbate systemic

risks within the general economy. An institution’s

underwriting standards typically consider the following:

•

Whether the business premise for each transaction is

sound and the borrower’s capital structure is

sustainable regardless of whether the transaction is

underwritten for the institution’s own portfolio or with

the intent to distribute.

•

A borrower’s capacity to repay and ability to de-lever

to a sustainable level over a reasonable period

underwriting standards typically consider the following:

•

Whether the business premise for each transaction is

sound and the borrower’s capital structure is

sustainable regardless of whether the transaction is

underwritten for the institution’s own portfolio or with

the intent to distribute.

•

A borrower’s capacity to repay and ability to de-lever

to a sustainable level over a reasonable period.

•

Expectations for the depth and breadth of due

diligence on leveraged transactions.

•

Standards for evaluating expected risk-adjusted

returns.

•

The degree of reliance on enterprise value and other

intangible assets for loan repayment, along with

acceptable valuation methodologies, and guidelines

for the frequency of periodic reviews of those values;

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•

Expectations for the degree of support provided by the

sponsor (if any), taking into consideration the

sponsor’s financial capacity, the extent of its capital

contribution at inception, and other motivating factors.

•

Whether credit agreement terms allow for the material

dilution, sale, or exchange of collateral or cash flow-

producing assets without lender approval;

•

Credit agreement covenant protections, including

financial performance (such as debt-to-cash flow,

interest coverage, or fixed charge coverage), reporting

requirements, and compliance monitoring.

•

Collateral requirements in credit agreements that

specify acceptable collateral and risk-appropriate

measures and controls, including acceptable collateral

types, loan-to-value guidelines, and appropriate

collateral valuation methodologies

, including

financial performance (such as debt-to-cash flow,

interest coverage, or fixed charge coverage), reporting

requirements, and compliance monitoring.

•

Collateral requirements in credit agreements that

specify acceptable collateral and risk-appropriate

measures and controls, including acceptable collateral

types, loan-to-value guidelines, and appropriate

collateral valuation methodologies. Standards for

asset-based loans that are part of the entire debt

structure outline expectations for the use of collateral

controls (for example, inspections, independent

valuations, and payment lockbox), other types of

collateral and account maintenance agreements, and

periodic reporting requirements; and

•

Whether loan agreements provide for distribution of

ongoing financial and other relevant credit

information to all participants and investors.

Credit Analysis

Effective underwriting and management of leveraged

lending risk is highly dependent on the quality of analysis

employed during the approval process as well as ongoing

monitoring. An institution’s analysis of leveraged lending

transactions typically ensures that:

•

Cash flow analyses do not rely on overly optimistic or

unsubstantiated projections of sales, margins, and

merger and acquisition synergies;

•

Liquidity analyses include performance metrics

appropriate for the borrower’s industry; predictability

of the borrower’s cash flow; measurement of the

borrower’s operating cash needs; and ability to meet

debt maturities;

•

Projections exhibit an adequate margin for

unanticipated merger-related integration costs;

•

Projections are stress tested for one or two downside

scenarios, including a covenant breach;

•

Transactions are reviewed at least quarterly to

determine variance from plan, the related risk

implications, and the accuracy of risk ratings and

accrual status;

•

Enterprise and collateral valuations are independently

derived or validated outside of the origination

function, are timely, and consider potential value

erosion;

•

Collateral liquidatio

ownside

scenarios, including a covenant breach;

•

Transactions are reviewed at least quarterly to

determine variance from plan, the related risk

implications, and the accuracy of risk ratings and

accrual status;

•

Enterprise and collateral valuations are independently

derived or validated outside of the origination

function, are timely, and consider potential value

erosion;

•

Collateral liquidation and asset sale estimates are

based on current market conditions and trends;

•

Potential collateral shortfalls are identified and

factored into risk rating and accrual decisions;

•

Contingency plans anticipate changing conditions in

debt or equity markets when exposures rely on

refinancing or the issuance of new equity; and

•

The borrower is adequately protected from interest

rate and foreign exchange risk.

Valuation Standards

Institutions often rely on enterprise value and other

intangibles when (1) evaluating the feasibility of a loan

request; (2) determining the debt reduction potential of

planned asset sales; (3) assessing a borrower’s ability to

access the capital markets; and, (4) estimating the strength

of a secondary source of repayment. Institutions may also

view enterprise value as a useful benchmark for assessing a

sponsor’s economic incentive to provide financial support.

Given the specialized knowledge needed for the

development of a credible enterprise valuation and the

importance of enterprise valuations in the underwriting and

ongoing risk assessment processes, enterprise valuations

should be performed by qualified persons independent of an

institution’s origination function.

There are several methods used for valuing businesses. The

most common valuation methods are assets, income, and

market. Asset valuation methods consider an enterprise’s

underlying assets in terms of its net going-concern or

liquidation value. Income valuation methods consider an

enterprise’s ongoing cash flows or earnings and apply

appropriate capitalization or discounting techniques

n.

There are several methods used for valuing businesses. The

most common valuation methods are assets, income, and

market. Asset valuation methods consider an enterprise’s

underlying assets in terms of its net going-concern or

liquidation value. Income valuation methods consider an

enterprise’s ongoing cash flows or earnings and apply

appropriate capitalization or discounting techniques.

Market valuation methods derive value multiples from

comparable company data or sales transactions. However,

final value estimates should be based on the method or

methods that give supportable and credible results. In many

cases, the income method is generally considered the most

reliable.

There are two common approaches employed when using

the income method. The “capitalized cash flow” method

determines the value of a company as the present value of

all future cash flows the business can generate in perpetuity.

An appropriate cash flow is determined and then divided by

a risk-adjusted capitalization rate, most commonly the

weighted average cost of capital. This method is most

appropriate when cash flows are predictable and stable. The

“discounted cash flow” method is a multiple-period

valuation model that converts a future series of cash flows

into current value by discounting those cash flows at a rate

of return (referred to as the “discount rate”) that reflects the

risk inherent therein. This method is most appropriate when

future cash flows are cyclical or variable over time. Both

income methods involve numerous assumptions, and

ash flow” method is a multiple-period

valuation model that converts a future series of cash flows

into current value by discounting those cash flows at a rate

of return (referred to as the “discount rate”) that reflects the

risk inherent therein. This method is most appropriate when

future cash flows are cyclical or variable over time. Both

income methods involve numerous assumptions, and

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therefore, supporting documentation should fully explain

the evaluator’s reasoning and conclusions.

When a borrower is experiencing a financial downturn or

facing adverse market conditions, a prudent lender will

reflect those adverse conditions in its assumptions for key

variables such as cash flow, earnings, and sales multiples

when assessing enterprise value as a potential source of

repayment. Changes in the value of a borrower’s assets are

typically tested under a range of stress scenarios, including

business conditions more adverse than the base case

scenario. Stress tests of enterprise values and their

underlying assumptions are generally conducted and

documented at origination of the transaction and

periodically

thereafter,

incorporating

the

actual

performance of the borrower and any adjustments to

projections. Prudent institutions perform their own

discounted cash flow analysis to validate the enterprise

value implied by proxy measures such as multiples of cash

flow, earnings, or sales.

Enterprise value estimates derived from even the most

rigorous procedures are imprecise and ultimately may not

be realized. Therefore, institutions relying on enterprise

value or illiquid and hard-to-value collateral typically have

policies that provide for appropriate loan-to-value ratios,

discount rates, and collateral margins

measures such as multiples of cash

flow, earnings, or sales.

Enterprise value estimates derived from even the most

rigorous procedures are imprecise and ultimately may not

be realized. Therefore, institutions relying on enterprise

value or illiquid and hard-to-value collateral typically have

policies that provide for appropriate loan-to-value ratios,

discount rates, and collateral margins. Based on the nature

of an institution’s leveraged lending activities, the prudent

institution establishes limits for the proportion of individual

transactions and the total portfolio that are supported by

enterprise value. Regardless of the methodology used, the

assumptions underlying enterprise-value estimates typically

are clearly documented, well supported, and understood by

the institution’s appropriate decision-makers and risk

oversight units. Further, an institution’s valuation methods

are appropriate for the borrower’s industry and condition.

Risk Rating Leveraged Loans

The risk rating of leveraged loans involves the use of

realistic repayment assumptions to determine a borrower’s

ability to de-lever to a sustainable level within a reasonable

period of time. For example, supervisors commonly assume

that the ability to fully amortize senior secured debt or the

ability to repay at least 50 percent of total debt over a five-

to-seven year period provides evidence of adequate

repayment capacity. If the projected capacity to pay down

debt from cash flow is nominal with refinancing the only

viable option, the credit will usually be adversely rated even

if it has been recently underwritten. In cases when

leveraged loan transactions have no reasonable or realistic

prospects to de-lever, a Substandard rating is likely.

Furthermore, when assessing debt service capacity,

extensions and restructures should be scrutinized to ensure

that the institution is not merely masking repayment

capacity problems by extending or restructuring the loan

even

if it has been recently underwritten. In cases when

leveraged loan transactions have no reasonable or realistic

prospects to de-lever, a Substandard rating is likely.

Furthermore, when assessing debt service capacity,

extensions and restructures should be scrutinized to ensure

that the institution is not merely masking repayment

capacity problems by extending or restructuring the loan.

If the primary source of repayment becomes inadequate, it

would generally be inappropriate for an institution to

consider enterprise value as a secondary source of

repayment unless that value is well supported. Evidence of

well-supported value may include binding purchase and sale

agreements with qualified third parties or thorough asset

valuations that fully consider the effect of the borrower’s

distressed circumstances and potential changes in business

and market conditions. For such borrowers, when a portion

of the loan may not be protected by pledged assets or a well-

supported enterprise value, examiners generally will rate

that portion Doubtful or Loss and place the loan on

nonaccrual status.

Risks in leveraged lending activities are considered in the

ALLL and capital adequacy analysis. For allowance

purposes, leverage exposures are typically taken into

account either through analysis of the estimated credit

losses from the discrete portfolio or as part of an overall

analysis of the portfolio utilizing the institution's internal

risk grades or other factors. At the transaction level,

exposures heavily reliant on enterprise value as a secondary

source of repayment are typically scrutinized to determine

the need for and adequacy of specific allocations.

Problem Credit Management

Individual action plans are typically formulated by

management when working with borrowers experiencing

diminished operating cash flows, depreciated collateral

values, or other significant plan variances

es heavily reliant on enterprise value as a secondary

source of repayment are typically scrutinized to determine

the need for and adequacy of specific allocations.

Problem Credit Management

Individual action plans are typically formulated by

management when working with borrowers experiencing

diminished operating cash flows, depreciated collateral

values, or other significant plan variances. Weak initial

underwriting of transactions, coupled with poor structure

and limited covenants, may make problem credit

discussions and eventual restructurings more difficult for an

institution as well as result in less favorable outcomes.

A financial institution generally formulates credit policies

that define expectations for the management of adversely

rated and other high-risk borrowers whose performance

departs significantly from planned cash flows, asset sales,

collateral values, or other important targets. These policies

typically stress the need for workout plans that contain

quantifiable objectives and measureable time frames.

Actions may include working with the borrower for an

orderly resolution while preserving the institution’s

interests, sale of the credit in the secondary market, or

liquidation of collateral. Problem credits should be

reviewed regularly for risk rating accuracy, accrual status,

recognition of impairment through specific allocations, and

charge-offs.

Reporting and Analytics

Diligent financial institutions regularly monitor higher risk

credits, including leveraged loans. Monitoring includes

’s

interests, sale of the credit in the secondary market, or

liquidation of collateral. Problem credits should be

reviewed regularly for risk rating accuracy, accrual status,

recognition of impairment through specific allocations, and

charge-offs.

Reporting and Analytics

Diligent financial institutions regularly monitor higher risk

credits, including leveraged loans. Monitoring includes

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management’s review of comprehensive reports about the

characteristics and trends in such exposures at least

quarterly, with summaries provided to the board of

directors. Policies and procedures typically identify the

fields to be populated and captured by a financial

institution’s MIS, which then yields accurate and timely

reporting to management and the board of directors that may

include the following:

•

Individual and portfolio exposures within and across

all business lines and legal vehicles, including the

pipeline;

•

Risk rating distribution and migration analysis,

including maintenance of a list of those borrowers

who have been removed from the leveraged portfolio

due to improvements in their financial characteristics

and overall risk profile;

•

Industry mix and maturity profile;

•

Metrics derived from probabilities of default and loss

given default;

•

Portfolio performance measures, including

noncompliance with covenants, restructurings,

delinquencies, non-performing amounts, and charge-

offs;

•

Amount of impaired assets and the nature of

impairment, and the amount of the ALLL attributable

to leveraged lending;

•

The aggregate level of policy exceptions and the

performance of that portfolio;

•

Exposures by collateral type, including unsecured

transactions and those where enterprise value will be

the source of repayment for leveraged loans

ncies, non-performing amounts, and charge-

offs;

•

Amount of impaired assets and the nature of

impairment, and the amount of the ALLL attributable

to leveraged lending;

•

The aggregate level of policy exceptions and the

performance of that portfolio;

•

Exposures by collateral type, including unsecured

transactions and those where enterprise value will be

the source of repayment for leveraged loans.

Reporting also typically considers the implications of

defaults that trigger pari-passu treatment for all

lenders and, thus, dilute the secondary support from

the sale of collateral;

•

Secondary market pricing data and trading volume,

when available;

•

Exposures and performance by deal sponsors. Deals

introduced by sponsors may, in some cases, be

considered exposure to related borrowers. An

institution should identify, aggregate, and monitor

potential related exposures;

•

Gross and net exposures, hedge counterparty

concentrations, and policy exceptions;

•

Actual versus projected distribution of the syndicated

pipeline, with regular reports of excess levels over the

hold targets for the syndication inventory. Well-

designed pipeline definitions clearly identify the type

of exposure. This includes committed exposures that

have not been accepted by the borrower, commitments

accepted but not closed, and funded and unfunded

commitments that have closed but have not been

distributed; and

•

Total and segmented leveraged lending exposures,

including subordinated debt and equity holdings,

alongside established limits. Reports typically

provide a detailed and comprehensive view of global

exposures, including situations when an institution has

indirect exposure to an obligor or is holding a

previously sold position as collateral or as a reference

asset in a derivative

distributed; and

•

Total and segmented leveraged lending exposures,

including subordinated debt and equity holdings,

alongside established limits. Reports typically

provide a detailed and comprehensive view of global

exposures, including situations when an institution has

indirect exposure to an obligor or is holding a

previously sold position as collateral or as a reference

asset in a derivative.

Borrower and counterparty leveraged lending reporting

typically consider exposures booked in other business units

throughout the institution, including indirect exposures such

as default swaps and total return swaps, naming the

distributed paper as a covered or referenced asset or

collateral exposure through repo transactions. Additionally,

the positions in the held for sale or traded portfolios or

through structured investment vehicles owned or sponsored

by the originating institution or its subsidiaries or affiliates

are typically considered.

Deal Sponsors

A financial institution that relies on sponsor support as a

secondary source of repayment typically develops

guidelines for evaluating the qualifications of financial

sponsors and implements processes to regularly monitor a

sponsor’s financial condition. Deal sponsors may provide

valuable support to borrowers such as strategic planning,

management, and other tangible and intangible benefits.

Sponsors may also provide sources of financial support for

borrowers that fail to achieve projections. Generally, a

financial institution rates a borrower based on an analysis of

the borrower’s standalone financial condition. However, a

financial institution may consider support from a sponsor in

assigning internal risk ratings when the institution can

document the sponsor’s history of demonstrated support as

well as the economic incentive, capacity, and stated intent

to continue to support the transaction

nancial institution rates a borrower based on an analysis of

the borrower’s standalone financial condition. However, a

financial institution may consider support from a sponsor in

assigning internal risk ratings when the institution can

document the sponsor’s history of demonstrated support as

well as the economic incentive, capacity, and stated intent

to continue to support the transaction. However, even with

documented capacity and a history of support, the sponsor’s

potential contributions may not mitigate supervisory

concerns absent a documented commitment of continued

support. An evaluation of a sponsor’s financial support

typically includes the following:

•

The sponsor’s historical performance in supporting its

investments, financially and otherwise;

•

The sponsor’s economic incentive to support,

including the nature and amount of capital contributed

at inception;

•

Documentation of degree of support (for example, a

guarantee, comfort letter, or verbal assurance);

•

Consideration of the sponsor’s contractual investment

limitations;

•

To the extent feasible, a periodic review of the

sponsor’s financial statements and trends, and an

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analysis of its liquidity, including the ability to fund

multiple deals;

•

Consideration of the sponsor’s dividend and capital

contribution practices;

•

The likelihood of the sponsor supporting a particular

borrower compared to other deals in the sponsor’s

portfolio; and,

•

Guidelines for evaluating the qualifications of a

sponsor and a process to regularly monitor the

sponsor’s performance.

Independent Credit Review

A financial institution with a strong and independent credit

review function demonstrates the ability to identify

portfolio risks and documented authority to escalate

inappropriate risks and other findings to their senior

management

rtfolio; and,

•

Guidelines for evaluating the qualifications of a

sponsor and a process to regularly monitor the

sponsor’s performance.

Independent Credit Review

A financial institution with a strong and independent credit

review function demonstrates the ability to identify

portfolio risks and documented authority to escalate

inappropriate risks and other findings to their senior

management. Due to the elevated risks inherent in

leveraged lending, and depending on the relative size of a

financial institution’s leveraged lending business, there is

greater importance for the institution’s credit review

function to assess the performance of the leveraged

portfolio more frequently and in greater depth than other

segments in the loan portfolio. To be most effective, such

assessments are performed by individuals with the expertise

and experience for these types of loans and the borrower’s

industry. Portfolio reviews are generally conducted at least

annually. For many financial institutions, the risk

characteristics of leveraged portfolios, such as high reliance

on enterprise value, concentrations, adverse risk rating

trends, or portfolio performance, may dictate more frequent

reviews.

A financial institution that staffs its internal credit review

function appropriately and ensures that the function has

sufficient resources is most capable of providing timely,

independent, and accurate assessments of leveraged lending

transactions. Effective reviews evaluate the level of risk,

risk rating integrity, valuation methodologies, and the

quality of risk management. Such internal credit reviews

that review the institution’s leveraged lending practices,

policies, and procedures provide management with a

complete assessment of the leveraged lending program

dependent, and accurate assessments of leveraged lending

transactions. Effective reviews evaluate the level of risk,

risk rating integrity, valuation methodologies, and the

quality of risk management. Such internal credit reviews

that review the institution’s leveraged lending practices,

policies, and procedures provide management with a

complete assessment of the leveraged lending program.

Stress Testing

A financial institution typically develops and implements

guidelines for conducting periodic portfolio stress tests on

loans originated to hold as well as loans originated to

distribute, and sensitivity analyses to quantify the potential

impact of changing economic and market conditions on its

asset quality, earnings, liquidity, and capital. The

sophistication of stress-testing practices and sensitivity

analyses are most effective when they are consistent with

the size, complexity, and risk characteristics of the

institution’s leveraged loan portfolio. To the extent a

financial institution is required to conduct enterprise-wide

stress tests, the leveraged portfolio should be included in

any such tests.

Conflicts of Interest

A financial institution typically develops appropriate

policies and procedures to address and to prevent potential

conflicts of interest when it has both equity and lending

positions. For example, an institution may be reluctant to

use an aggressive collection strategy with a problem

borrower because of the potential impact on the value of an

institution’s equity interest. A financial institution may

encounter pressure to provide financial or other privileged

client information that could benefit an affiliated equity

investor. Such conflicts also may occur when the

underwriting financial institution serves as financial advisor

to the seller and simultaneously offers financing to multiple

buyers (that is, stapled financing)

an

institution’s equity interest. A financial institution may

encounter pressure to provide financial or other privileged

client information that could benefit an affiliated equity

investor. Such conflicts also may occur when the

underwriting financial institution serves as financial advisor

to the seller and simultaneously offers financing to multiple

buyers (that is, stapled financing). Similarly, there may be

conflicting interests among the different lines of business

within a financial institution or between the financial

institution and its affiliates. When these situations occur,

potential conflicts of interest arise between the financial

institution and its customers. Effective policies and

procedures clearly define potential conflicts of interest,

identify appropriate risk management controls and

procedures, enable employees to report potential conflicts

of interest to management for action without fear of

retribution, and ensure compliance with applicable laws.

Further, an established training program for employees on

appropriate practices to follow to avoid conflicts of interest

is an effective risk management practice.

Oil and Gas Lending

Industry Overview

Oil and gas (O&G) lending is complex and highly

specialized due to factors such as global supply and

demand,

geopolitical

uncertainty,

weather-related

disruptions, fluctuations and volatility in currency markets

(i.e. the strength of the U.S. dollar compared to global

currency markets), and changes in environmental and other

governmental policies. As such, companies and borrowers

that are directly or indirectly tied to the O&G industry

frequently experience expansion and contraction within key

operational areas of their businesses that will directly

impact their financial condition and repayment capacity.

The O&G industry has four interconnected segments:

•

Upstream - exploration and production (E&P)

companies

•

Midstream - transporting, treating, processing, storing,

and marketing to Upstream companies

to the O&G industry

frequently experience expansion and contraction within key

operational areas of their businesses that will directly

impact their financial condition and repayment capacity.

The O&G industry has four interconnected segments:

•

Upstream - exploration and production (E&P)

companies

•

Midstream - transporting, treating, processing, storing,

and marketing to Upstream companies

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RMS Manual of Examination Policies

3.2-17

Loans (05/23)

Federal Deposit Insurance Corporation

•

Downstream - refining and marketing

•

Support/Services - equipment, services, or support

activities (e.g. drilling, workover units, and water

hauling services)

O&G lending to Upstream companies for E&P activities is

a specialized form of lending, and is the primary focus of

this section (see Reserve-Based Lending below). Loans to

Midstream, Downstream and Support/Service companies

are generally structured similar to other commercial loans.

In addition, Midstream companies often raise capital

through Master Limited Partnerships that are publicly

traded. The highest credit risk is typically found in

Support/Services and Upstream lending, which are more

directly affected by changes in production and commodity

prices.

Reserve-Based Lending

Loans for E&P activities are typically secured by proved

reserves and governed by a borrowing base, an arrangement

known as reserve-based lending, or RBL. Effective credit

risk

management

in

RBL

requires

conservative

underwriting, appropriate structuring, experienced and

knowledgeable lending staff, and sound loan administration

practices. It is also important for the board and senior

management to consider the unique risks associated with

this type of lending when developing RBL policies and

approving and administering such loans

RBL. Effective credit

risk

management

in

RBL

requires

conservative

underwriting, appropriate structuring, experienced and

knowledgeable lending staff, and sound loan administration

practices. It is also important for the board and senior

management to consider the unique risks associated with

this type of lending when developing RBL policies and

approving and administering such loans. These risks

include, but are not limited to, credit, concentration, market

volatility/pricing, limited purpose collateral, production,

operational, legal, compliance/environmental, interest rate,

liquidity, strategic, and third-party risk.

RBL may appear similar to traditional asset based lending

(ABL), but there are notable differences. The primary

source of repayment for ABL is the orderly liquidation of

the collateral (receivables and inventory) into cash. Such

loans are typically structured with strong controls over the

collateral, such as a lock box arrangement. In contrast, the

primary source of repayment for RBL is the cash flows

derived from the extraction of O&G reserves. An

independent, third-party reserve engineering report serves

as the primary underwriting tool to estimate the future cash

stream and establish a “borrowing base,” which is a

collateral base agreed to by the borrower and lender that is

used to limit the amount of funds the lender advances the

borrower. The borrowing base is subject to periodic

redeterminations, typically semiannually, that can result in

the reduction of the borrowing base commitment when

commodity prices and reserves are declining.

Types of Reserves

Lenders should generally only consider proved reserves,

defined as having at least a 90 percent probability that the

quantities actually recovered will equal or exceed the

estimate, in determining collateral value. Within the proved

reserves category, Proved Developed Producing (PDP),

Proved Developed Non-Producing (PDNP), and Proved

Undeveloped (PUD) reserves are collectively known as P1

Lenders should generally only consider proved reserves,

defined as having at least a 90 percent probability that the

quantities actually recovered will equal or exceed the

estimate, in determining collateral value. Within the proved

reserves category, Proved Developed Producing (PDP),

Proved Developed Non-Producing (PDNP), and Proved

Undeveloped (PUD) reserves are collectively known as P1.

As described below, PDNP and PUD require capital

expenditures (CAPEX) to bring the non-producing and

undeveloped reserves online as PDP:

•

PDP represents reserves that are recoverable from

existing wells with existing equipment and operating

methods that are producing at the time of the

engineering report estimate.

•

PDNP reserves include both shut-in (PDSI) and

behind the pipe (PDBP) reserves, and production can

be initiated or restored with relatively low

expenditures compared to the cost of drilling a new

well.

o

PDSI reserves are completion intervals that are

open, but have not started producing; were shut-in

for market conditions or pipeline connections; or

not capable of production for mechanical reasons.

o

PDBP reserves are those expected to be recovered

from existing wells that require additional

completion work or future completion prior to the

start of production.

•

PUD reserves are expected to be recovered only after

making future investment. These reserves have been

proved by independent engineering reports, but do not

have a well infrastructure in place.

Other categories of reserves include “probable” (P2) and

“possible” (P3). Probable reserves are relatively uncertain,

while possible reserves are considered speculative in nature.

Probable and possible reserves should not receive any value

when determining the borrowing base

t. These reserves have been

proved by independent engineering reports, but do not

have a well infrastructure in place.

Other categories of reserves include “probable” (P2) and

“possible” (P3). Probable reserves are relatively uncertain,

while possible reserves are considered speculative in nature.

Probable and possible reserves should not receive any value

when determining the borrowing base.

Reserve Engineering Reports

Reserve engineering reports are an estimate of the volumes

of O&G reserves that are likely to be recovered based on

reasonable assumptions regarding physical characteristics

of the reservoir, available technology, and operating

efficiencies. The significant reliance on engineering reports

in underwriting RBL facilities requires sound internal

controls over the collateral evaluation process. Reserve

reports must be objective; based on reasonable, well-

documented assumptions; and completed independently of

the loan origination and collection functions. It is important

for management to document the qualifications and

independence of the engineer, and to periodically evaluate

the production performance, which includes a comparison

of production projections to actual results.

RBL collateral value consists of a point-in-time estimate of

the present value (PV) of future net revenue (FNR) derived

LOANS

Section 3.2

Loans (05/23)

3.2-18

RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

from the production and sale of existing O&G reserves, net

of operating expenses, production taxes, royalties, and

CAPEX, discounted at an appropriate rate. The engineering

reports

should

contain

sufficient

information

and

documentation to support the assumptions and the analysis

used to derive the forecasted cash flows and discounted PV

Policies

Federal Deposit Insurance Corporation

from the production and sale of existing O&G reserves, net

of operating expenses, production taxes, royalties, and

CAPEX, discounted at an appropriate rate. The engineering

reports

should

contain

sufficient

information

and

documentation to support the assumptions and the analysis

used to derive the forecasted cash flows and discounted PV.

Well-managed banks provide clear guidance to the engineer

at

engagement

regarding

discount

rates,

pricing

assumptions, operating expense escalation rates, and risk-

adjustment guidelines limiting higher risk reserves. The

engineer will conduct an analysis of production reports from

the subject properties, and project estimated reserve

depletion.

Borrowing Base

The collateral base securing each facility should be

primarily comprised of PDP reserves. Inclusion of PDNP

reserves in the collateral evaluation should be supported

with sufficient documentation to demonstrate that the

borrower has the financial capacity to convert PDNP

reserves to PDP reserves by making the necessary

investments to restore or initiate production within the near-

term.

To include PUDs in the borrowing base calculation, the

borrower should have sufficient liquidity and positive Free

Cash Flow to meet operational needs, and debt service

requirements, as well as be able to fund (or obtain the

funding for) the CAPEX that would be required to convert

these undeveloped reserves into production. Potential sale

and/or marketability of the PUDs can also be considered

when evaluating collateral values, provided there is

adequate documentation of recent PUD sales.

Lenders use risk-adjustment factors to lower the value of

unseasoned producing and non-producing reserves before

applying borrowing base advance rates. It is important to

consider policy limits on production vs

production. Potential sale

and/or marketability of the PUDs can also be considered

when evaluating collateral values, provided there is

adequate documentation of recent PUD sales.

Lenders use risk-adjustment factors to lower the value of

unseasoned producing and non-producing reserves before

applying borrowing base advance rates. It is important to

consider policy limits on production vs. non-production

reserves, the oil and gas mix, maximum production coming

from one well (single well concentration risk), and other

risk-adjustment factors. Ideally, management achieves

diversification in the geographic location of reserve fields,

and establishes limits on the lowest number of producing

wells needed to establish an acceptable borrowing base.

Typically, the advance rate for high-quality proved (P1)

reserves rarely exceed 65 percent (a typical range is 50 to

65 percent) of the PV of FNR. If the lender determines that

PDNP or PUD reserves are to be considered in the

borrowing base, these reserves should generally not exceed

25 to 35 percent of the total borrowing base. In addition,

PDNP and PUD reserves should be risk-adjusted (65 to 75

percent for PDNP and 25 to 50 percent for PUD, for

example) prior to applying the advance rate. Lenders may

apply separate risk-adjusted advance rates for each proved

reserve category in the borrowing base. During extended

periods of low or declining commodity prices, it is not

uncommon for banks to increase the risk adjustment for

PDNP and PUD reserves.

As part of the underwriting process, lending personnel

typically prepare both base-case and sensitivity-case

analyses that focus on the ability of converting the

underlying collateral into cash to repay the loan, including

an estimate of the impact that sustained adverse changes in

market conditions would have on a company’s repayment

ability

the risk adjustment for

PDNP and PUD reserves.

As part of the underwriting process, lending personnel

typically prepare both base-case and sensitivity-case

analyses that focus on the ability of converting the

underlying collateral into cash to repay the loan, including

an estimate of the impact that sustained adverse changes in

market conditions would have on a company’s repayment

ability. A base-case analysis uses standard assumption

scenarios and generally includes a discount to current prices

against the forward curve (projected futures pricing

estimates of the commodity). A sensitivity case analysis

subjects the O&G reserves to adverse external factors such

as lower market prices and/or higher operating expenses to

ascertain the effect on loan repayment. Full debt service

capacity (DSC) is typically analyzed using both the base-

case and sensitivity-case scenarios.

Discount Rates

The Securities and Exchange Commission (SEC) requires

publicly traded companies to report the value of their

reserves using a standard discount rate of 10 percent in

accordance with ASC Topic 932, Extractive Activities - Oil

and Gas. In evaluating collateral valuations for RBL

facilities, banks often utilize alternative discount rates. For

creditworthy borrowers and during more benign operating

cycles, a 9 percent discount rate is commonly used. For

higher-risk borrowers or during volatile or declining market

cycles for O&G, higher discount rates are typically used. If

a discount rate is selected that significantly differs from

generally accepted discount rates, examiners should assess

management’s documentation supporting its rationale.

Some banks may use multiple discount rates under certain

circumstances. An example may include establishing a

standard discount rate for performing credits and a higher

rate for higher risk facilities

ypically used. If

a discount rate is selected that significantly differs from

generally accepted discount rates, examiners should assess

management’s documentation supporting its rationale.

Some banks may use multiple discount rates under certain

circumstances. An example may include establishing a

standard discount rate for performing credits and a higher

rate for higher risk facilities.

Price Decks

Prudent management regularly evaluates, and updates as

necessary, its pricing assumptions for RBL, commonly

referred to as the institution’s price deck. The price deck is

a forecast used to derive cash flow and collateral value

assumptions, and typically is approved by the board of

directors or a specifically designated board committee.

Pricing assumptions typically represent the most significant

variable in driving the final estimate of value, and must be

well-supported.

Each institution’s price deck typically reflects both base-

case and sensitivity-case pricing scenarios. Pricing

assumptions for the sensitivity case are generally

LOANS

Section 3.2

RMS Manual of Examination Policies

3.2-19

Loans (05/23)

Federal Deposit Insurance Corporation

sufficiently conservative and used to determine whether the

borrower has the financial capacity to generate adequate

cash flow to repay the debt during a prolonged low

commodity price environment. Price deck considerations

include, for example, current commodity pricing, forward

curve projections (future price considerations), cost

assumptions, discount rates, and timing of the various

reports. Management also typically documents any risk-

based adjustments applied to each proved reserve category.

While the risk-adjusted base case projections will generally

be used to underwrite RBLs, consideration is also given to

the ability to repay the debt using the risk-adjusted

sensitivity case to determine potential exposure due to

adverse market price fluctuations

of the various

reports. Management also typically documents any risk-

based adjustments applied to each proved reserve category.

While the risk-adjusted base case projections will generally

be used to underwrite RBLs, consideration is also given to

the ability to repay the debt using the risk-adjusted

sensitivity case to determine potential exposure due to

adverse market price fluctuations.

Loan Structure

RBL credit facilities are typically structured as a revolving

line of credit (RLOC), a reducing revolving line of credit

(RRLOC), or an amortizing term loan, governed by a well-

supported and fully documented borrowing base. These

credit facilities generally fully amortize within the half-life

of the reserves (that is, the time in years required to produce

one-half of the total estimated recoverable production) with

repayment aligning with projected cash flows. In other

words, the term of the loans should be tied to the economic

life of the underlying asset. This is often represented as the

“reserve tail tests” that are based on the economic half-life

of the reserves or the cash flow remaining after projected

loan payout.

Loan durations should be fairly short-term and directly tied

to the economic life of the asset (generally 50 to 60 percent

of the economic life of the proved reserves or the proved

reserves’ half-life). The terms generally depend on the

projected and actual reserve production (reserve run data),

as well as the type and range of collateral (PDP, PDNP, or

PUD). A reasonable portion of the estimated revenues

should remain after the debt has fully amortized (reserve

tail). Borrowing bases should be re-determined at least

semiannually, subject to an updated reserve engineering

report.

Covenants

Appropriate use of covenants is imperative in managing

credit risk for O&G loans. Lenders typically require

financial covenants to instill discipline in the lending

relationship, including the borrower’s leverage position,

repayment capacity, and liquidity

ve

tail). Borrowing bases should be re-determined at least

semiannually, subject to an updated reserve engineering

report.

Covenants

Appropriate use of covenants is imperative in managing

credit risk for O&G loans. Lenders typically require

financial covenants to instill discipline in the lending

relationship, including the borrower’s leverage position,

repayment capacity, and liquidity. In addition, well-

designed

covenants

limit

cash

distributions

to

owners/shareholders, and include standard performance and

financial reporting requirements. Examples of commonly

used ratios/covenants for evaluating E&P companies

include Free Cash Flow (FCF), Interest Coverage, Fixed

Charge Coverage, Current Ratio, Quick Ratio, Senior

Debt/EBITDA(X), and Total Debt/EBITDA(X). The

calculation of earnings before interest, taxes, depreciation,

and

amortization

(EBITDA)

typically

incorporates

maintenance CAPEX (X) due to its impact on the amount

of projected FCF that is available after debt service to

support operations.

Hedging

When used properly, hedging may be an effective tool to

help protect the borrower and the lender from sharp

commodity price declines by providing a stable cash flow

stream. E&P companies frequently use hedging

instruments such as futures contracts, swaps, collars, and

put options to reduce price risk exposure. Generally, hedges

should be limited to no more than 85 percent of projected

production volumes. Counterparties are typically limited to

reputable, financially sound companies that are approved in

accordance with the institution’s O&G loan policy. If the

hedges are taken as collateral or part of the borrowing base,

the advance rate and any limitations on the hedging position

should be documented in the loan agreement. If hedges are

sold or monetized, the proceeds of such are generally

applied to the respective debt

ited to

reputable, financially sound companies that are approved in

accordance with the institution’s O&G loan policy. If the

hedges are taken as collateral or part of the borrowing base,

the advance rate and any limitations on the hedging position

should be documented in the loan agreement. If hedges are

sold or monetized, the proceeds of such are generally

applied to the respective debt.

Borrower and Financial Analysis

Management should have a clear understanding of the

overall financial health of the borrower that includes an

assessment of the borrower’s ability to maintain operations

through adverse market conditions. E&P companies in

sound financial condition should have strong cash flow

from reliable revenue sources and well-controlled operating

expenses. Companies should also have adequate sources of

liquidity and effective working capital management, sound

reserve development practices, well-defined criteria for

divestiture, adequate capital structure, manageable levels of

debt, and appropriate financial reporting. As part of the

overall financial analysis of the relationship, updated

engineering data should be well-documented and should

enable the lender to determine the borrower’s capacity to

service the debt. Any over-advance situation should have a

reasonable plan and timeframe to cure the over-advance.

The principals of successful E&P companies should be

experienced and have a well-documented track record of

managing through all stages of the business cycle. In good

times, company management should be able to identify,

acquire, and develop reserves profitably and in line with

expectations. During declining price cycles, company

management should be able to demonstrate the ability to

streamline operations, maintain reasonable production,

manage working capital, strategically reduce CAPEX, and

make sound divestitures to ensure repayment of debt

In good

times, company management should be able to identify,

acquire, and develop reserves profitably and in line with

expectations. During declining price cycles, company

management should be able to demonstrate the ability to

streamline operations, maintain reasonable production,

manage working capital, strategically reduce CAPEX, and

make sound divestitures to ensure repayment of debt. Bank

management should evaluate the borrower’s cost cycle,

which reflects not only the ability to generate cash flow

LOANS

Section 3.2

Loans (05/23)

3.2-20

RMS Manual of Examination Policies

Federal Deposit Insurance Corporation

from production, but also the CAPEX necessary to replace

depleted reserves. Working capital management is

critically important, as delinquent payments to vendors can

result in a negative working capital position (due to

accounts payable increasing) and an increased leverage

ratio.

Financial analysis typically includes the following:

•

Adequacy of operating cash flows to service existing

total debt;

•

Overall compliance with financial covenants,

including borrowing base limitations as detailed in the

loan agreement;

•

Reasonableness of the company’s budget assumptions

and projections;

•

Comparison of borrower provided production

projections with actual results;

•

Working capital, tangible net worth, and leverage

positions; and

•

Impact of capital expenses and recent acquisitions.

O&G Loan Policy Guidelines

The O&G loan policy should provide sufficient guidance to

loan officers, clearly convey appropriate policy limitations

and monitoring procedures, and detail appropriate

underwriting standards and practices. The O&G policy

should clearly indicate those industry segments (Upstream,

Midstream, Downstream, and Support/Services) the board

chooses to lend to and include guidance on each of those

segments

oan policy should provide sufficient guidance to

loan officers, clearly convey appropriate policy limitations

and monitoring procedures, and detail appropriate

underwriting standards and practices. The O&G policy

should clearly indicate those industry segments (Upstream,

Midstream, Downstream, and Support/Services) the board

chooses to lend to and include guidance on each of those

segments.

For institutions engaged in RBL, appropriate policies

address reserve measurement and valuation analysis,

borrowing base determinations, production history analysis,

financial statement and ratio analysis, commitment

advances, discount rates, price deck formulation, financial

covenants, steps to cure an over-advance situation, and

ALLL considerations. Specific guidelines typically cover

the following areas:

•

Lending objectives, risk appetite, portfolio limits,

target market, and concentration limits;

•

Methodology and requirements for monitoring O&G

markets, including pricing, supply and demand trends,

overall market trends, and industry analysis;

•

Board and committee oversight over the O&G lending

and engineering departments;

•

Officer and committee lending limits;

•

Borrowing base calculations and risk-adjustments;

•

Price deck considerations and adjustments;

•

Advance rates, risk-adjusted values for PDP, PDNP,

and PUD reserves, and requirement to risk adjust the

discount value of nonproducing reserves before

applying advance rates;

•

Frequency and required details of borrowing base

redeterminations and price deck revaluations;

•

Requirements for independent engineering reports and

analysis thereof;

•

Well concentration guidelines and maximum per

single well limits;

•

Financial covenants, minimum ratio and other

financial information requirements, and review

requirements (e.g

roducing reserves before

applying advance rates;

•

Frequency and required details of borrowing base

redeterminations and price deck revaluations;

•

Requirements for independent engineering reports and

analysis thereof;

•

Well concentration guidelines and maximum per

single well limits;

•

Financial covenants, minimum ratio and other

financial information requirements, and review

requirements (e.g. current ratio, fixed charge

coverage, cash flow coverage, leverage ratios);

•

Collateral valuation requirements, including required

remaining collateral at payout;

•

Renewal and restructuring guidelines, including

nonaccrual and troubled debt restructuring

implications;

•

Remedies for declining collateral or over-advanced

situations, such as Monthly Commitment Reductions,

pledge of additional reserves as collateral, and sale of

non-productive reserves;

•

Minimum required insurance (including property,

liability, and environmental);

•

Defined loan safety or coverage factors and/or loan

value policies, including other debt that is “pari-

passu” (i.e. all debts sharing equally in the production

cash flows available to amortize debt);

•

Typical amortization, payout, and loan repayment

terms, including maximum terms for production

revolvers and term loans;

•

Guarantor requirements;

•

Hedging requirements, policies, and limitations;

•

Stress-testing and sensitivity analysis and

requirements thereof; and

•

Monitoring requirements for the risks inherent in

loans dependent on royalty interests in production

revenues for repayment.

Credit Risk Rating Assessment and Classification

Guidelines

An appropriate O&G loan policy also addresses specific

credit risk review procedures for the O&G portfolio and

O&G loan grading criteria. Risk rating definitions should

be clearly defined. RBL that are adequately protected by

the current sound worth and debt service capacity of the

borrower, guarantor, or underlying collateral generally will

not be adversely classified for supervisory purposes

ppropriate O&G loan policy also addresses specific

credit risk review procedures for the O&G portfolio and

O&G loan grading criteria. Risk rating definitions should

be clearly defined. RBL that are adequately protected by

the current sound worth and debt service capacity of the

borrower, guarantor, or underlying collateral generally will

not be adversely classified for supervisory purposes.

However, if any of the following circumstances are present,

a more in-depth and comprehensive analysis of the credit is

needed to determine whether the loan has potential or well-

defined weaknesses:

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Section 3.2

RMS Manual of Examination Policies

3.2-21

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Federal Deposit Insurance Corporation

•

The loan balance exceeds 65 percent of the PV of

FNR of PDP, or the cash flow analysis indicates that

the loan will not amortize within the reserve half-life;

•

The credit is not performing in accordance with

contractual terms (repayment of interest and

principal);

•

Advance rates exceed the institution’s limits or

industry standards for proved reserves;

•

Frequent over-advances occur at subsequent

borrowing base redeterminations;

•

Excessive operating leverage;

•

Covenant defaults;

•

Delinquent payables, or other evidence of poor

working capital management;

•

Significant current or likely future disruptions in

production;

•

Frequent financial statement revisions or changes in

chosen accounting method;

•

Maintenance or capital expenditures significantly

exceed budgeted forecasts; or

•

The credit is identified by the institution as a

“distressed” credit.

Examiners are to consider all information relevant to

evaluating the prospects that the loan will be repaid,

including the borrower’s creditworthiness, the cash flow

provided by the borrower’s operation, the collateral

supporting the loan, integrity and reliability of the

engineering data, borrowing base considerations, primary

source of repayment, and any support provided by

financially responsible guarantors and co-borrowers

tion relevant to

evaluating the prospects that the loan will be repaid,

including the borrower’s creditworthiness, the cash flow

provided by the borrower’s operation, the collateral

supporting the loan, integrity and reliability of the

engineering data, borrowing base considerations, primary

source of repayment, and any support provided by

financially responsible guarantors and co-borrowers. If the

borrower’s circumstances reveal well-defined weaknesses,

adverse classification of the loan relationship is likely

warranted. The level and severity of classification of

distressed, collateral-dependent RBLs will depend on the

quality of the underlying collateral, based on the most recent

re-determined and risk-adjusted borrowing base that is

contractually obligated to be funded.

The portion of the loan commitment(s) secured by the NPV

of total risk-adjusted proved reserves should be classified

Substandard. When the potential for loss may be mitigated

by the outcome of certain pending events, or when loss is

expected but the amount of the loss cannot be reasonably

determined, the remaining balance secured by the NPV of

total unrisked proved reserves should be classified

Doubtful. The portion of the loan commitment(s) that

exceeds 100 percent of the NPV of total unrisked proved

reserves, and is uncollectible, should be classified Loss.

These guidelines may be adjusted depending on the

borrower’s specific situation and should not replace

examiner judgment.

The following tables illustrate an example of the rating

methodology for a classified borrower. Actual pricing,

discount rates, and risk adjustment factors applied by the

institution may vary according to current market conditions

and the nature of the reserves. Examiners should closely

review the key assumptions made by the institution in

arriving at the current collateral valuation

ent.

The following tables illustrate an example of the rating

methodology for a classified borrower. Actual pricing,

discount rates, and risk adjustment factors applied by the

institution may vary according to current market conditions

and the nature of the reserves. Examiners should closely

review the key assumptions made by the institution in

arriving at the current collateral valuation.

Example: Collateral Valuation ($ Million)

Discounted NPV at 9% and using NYMEX Strip Pricing

Valuation

Hedges

PDP

PDNP

PUD

Total

Basis

Proved

Unrisked

$10

$50

$20

$40

$120

NPV

Risk

100%

100%

75%

50%

adjustment

factors

Risked &

$10

$50

$15

$20

$95

Adjusted

NPV

Total collateral value:

$95

Example: Classification ($ Million)

Borrowing base commitment on RBL is $125 million

TC

Pass

SM

II

III

IV

RBL

$125

$95

$25

$5

Total $125

$95

$25

$5

TC: Total Commitment SM: Special Mention

II: Substandard III: Doubtful

IV: Loss

Note: The $25 million of Doubtful represents the difference

between the unrisked NPV and the risked NPV. If the

borrower's prospects for further developing PDNP and PUD

reserves to producing status are unlikely or not supported by

a pending event, this amount should be reflected as Loss.

Institutions should follow accounting principles when

determining whether a loan should be placed on nonaccrual.

Each extension should be independently evaluated to

determine whether it should be on nonaccrual; that is,

nonaccrual status should not be automatically applied to

multiple loans or extensions of credit to a single borrower if

only one loan meets the criteria for nonaccrual status.

However, multiple loans to one borrower that are structured

as pari-passu to principal and interest and supported by the

same repayment source should not be treated differently for

nonaccrual or troubled debt restructuring purposes,

regardless of collateral lien position

to

multiple loans or extensions of credit to a single borrower if

only one loan meets the criteria for nonaccrual status.

However, multiple loans to one borrower that are structured

as pari-passu to principal and interest and supported by the

same repayment source should not be treated differently for

nonaccrual or troubled debt restructuring purposes,

regardless of collateral lien position.

Real Estate Loans

General

Real estate loans are part of the loan portfolios of almost all

commercial banks. Real estate loans include credits

advanced for the purchase of real property. However, the

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Federal Deposit Insurance Corporation

term may also encompass extensions granted for other

purposes, but for which primary collateral protection is real

property.

The degree of risk in a real estate loan depends primarily on

the loan amount in relation to collateral value, the interest

rate, and most importantly, the borrower's ability to repay in

an orderly fashion. It is extremely important that an

institution's real estate loan policy ensure that loans are

granted with the reasonable probability the debtor will be

able and willing to meet the payment terms. Placing undue

reliance upon a property's appraised value in lieu of an

adequate initial assessment of a debtor's repayment ability

is a potentially dangerous mistake.

Historically, many banks have jeopardized their capital

structure by granting ill-considered real estate mortgage

loans

e

granted with the reasonable probability the debtor will be

able and willing to meet the payment terms. Placing undue

reliance upon a property's appraised value in lieu of an

adequate initial assessment of a debtor's repayment ability

is a potentially dangerous mistake.

Historically, many banks have jeopardized their capital

structure by granting ill-considered real estate mortgage

loans. Apart from unusual, localized, adverse economic

conditions which could not have been foreseen, resulting in

a temporary or permanent decline in realty values, the

principal errors made in granting real estate loans include

inadequate regard to normal or even depressed realty values

during periods when it is in great demand thus inflating the

price structure, mortgage loan amortization, the maximum

debt load and repayment capacity of the borrower, and

failure to reasonably restrict mortgage loans on properties

for which there is limited demand.

A principal indication of a troublesome real estate loan is an

improper relationship between the amount of the loan, the

potential sale price of the property, and the availability of a

market. The potential sale price of a property may or may

not be the same as its appraised value. The current potential

sale price or liquidating value of the property is of primary

importance and the appraised value is of secondary

importance. There may be little or no current demand for

the property at its appraised value and it may have to be

disposed of at a sacrifice value.

Examiners must appraise not only individual mortgage

loans, but also the overall mortgage lending and

administration policies to ascertain the soundness of its

mortgage loan operations as well as the liquidity contained

in the account

condary

importance. There may be little or no current demand for

the property at its appraised value and it may have to be

disposed of at a sacrifice value.

Examiners must appraise not only individual mortgage

loans, but also the overall mortgage lending and

administration policies to ascertain the soundness of its

mortgage loan operations as well as the liquidity contained

in the account. Institutions generally establish policies that

address the following factors: the maximum amount that

may be loaned on a given property, in a given category, and

on all real estate loans; the need for appraisals (professional

judgments of the present and/or future value of the real

property) and for amortization on certain loans.

Real Estate Lending Standards

Section 18(o) of the FDI Act requires the federal banking

agencies to adopt uniform regulations prescribing standards

for loans secured by liens on real estate or made for the

purpose of financing permanent improvements to real

estate. For FDIC-supervised institutions, Part 365 of the

FDIC Rules and Regulations requires each institution to

adopt and maintain written real estate lending policies that

are consistent with sound lending principles, appropriate for

the size of the institution and the nature and scope of its

operations. These policies generally enable management to

effectively identify, measure, monitor, and control the risks

associated with real estate lending. The level and

complexity of risk-monitoring techniques for real estate

lending typically is commensurate with the level of real

estate activity and the nature and complexity of the

institution’s market

and the nature and scope of its

operations. These policies generally enable management to

effectively identify, measure, monitor, and control the risks

associated with real estate lending. The level and

complexity of risk-monitoring techniques for real estate

lending typically is commensurate with the level of real

estate activity and the nature and complexity of the

institution’s market. Within these general parameters, the

regulation specifically requires an institution to establish

policies that include:

•

Portfolio diversification standards;

•

Prudent underwriting standards including loan-to-

value limits;

•

Loan administration procedures;

•

Documentation, approval and reporting requirements;

and

•

Procedures for monitoring real estate markets within

the institution's lending area.

These policies also should consider the Interagency

Guidelines for Real Estate Lending Policies and must be

reviewed and approved at least annually by the institution's

board of directors.

The interagency guidelines, which are an appendix to Part

365, are intended to help institutions satisfy the regulatory

requirements by outlining the general factors to consider

when developing real estate lending standards. The

guidelines suggest maximum supervisory loan-to-value

(LTV) limits for various categories of real estate loans and

explain how the agencies will monitor their use.

The Interagency Guidelines for Real Estate Lending

Policies indicate that institutions should establish their own

internal LTV limits consistent with their needs. These

internal

limits

should

not

exceed

the

following

recommended supervisory limits:

•

65 percent for raw land;

•

75 percent for land development;

•

80 percent for commercial, multi-family, and other

non-residential construction;

•

85 percent for construction of a 1-to-4 family

residence;

•

85 percent for improved property; and

•

Owner-occupied 1-to-4 family home loans have no

suggested supervisory LTV limits

should

not

exceed

the

following

recommended supervisory limits:

•

65 percent for raw land;

•

75 percent for land development;

•

80 percent for commercial, multi-family, and other

non-residential construction;

•

85 percent for construction of a 1-to-4 family

residence;

•

85 percent for improved property; and

•

Owner-occupied 1-to-4 family home loans have no

suggested supervisory LTV limits. However, for any

such loan with an LTV ratio that equals or exceeds 90

percent at origination, an institution should require

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appropriate credit enhancement in the form of either

mortgage insurance or readily marketable collateral.

Certain real estate loans are exempt from the supervisory

LTV limits because of other factors that significantly reduce

risk. These include loans guaranteed or insured by the

federal, state or local government as well as loans to be sold

promptly in the secondary market without recourse. A

complete list of excluded transactions is included in the

guidelines.

Because there are a number of credit factors besides LTV

limits that influence credit quality, loans that meet the

supervisory LTV limits should not automatically be

considered sound, nor should loans that exceed the

supervisory LTV limits automatically be considered high

risk. However, loans that exceed the supervisory LTV limit

should be identified in the institution's records and the

aggregate amount of these loans reported to the institution's

board of directors at least quarterly. The guidelines further

state that the aggregate amount of loans in excess of the

supervisory LTV limits should not exceed the institution's

total capital. Moreover, within that aggregate limit, the total

loans for all commercial, agricultural and multi-family

residential properties (excluding 1-to-4 family home loans)

should not exceed 30 percent of total capital

ectors at least quarterly. The guidelines further

state that the aggregate amount of loans in excess of the

supervisory LTV limits should not exceed the institution's

total capital. Moreover, within that aggregate limit, the total

loans for all commercial, agricultural and multi-family

residential properties (excluding 1-to-4 family home loans)

should not exceed 30 percent of total capital.

Management and the board at each institution typically

establish an appropriate internal process for the review and

approval of loans that do not conform to internal policy

standards. The approval of any loan that is an exception to

policy typically is supported by a written justification that

clearly details all of the relevant credit factors supporting

the underwriting decision. Exception loans of a significant

size often are individually reported to the board.

Prudent management and boards monitor compliance with

internal policies and maintain reports of all exceptions to

policy. Examiners should review loan policy exception

reports to determine whether exceptions are adequately

documented and appropriate in light of all the relevant credit

considerations.

Institutions should develop policies that are clear, concise,

consistent with sound real estate lending practices, and meet

their needs. Policies should not be so complex that they

place excessive paperwork burden on the institution.

Therefore, when evaluating compliance with Part 365,

examiners should carefully consider the following:

•

The size and financial condition of the institution;

•

The nature and scope of the institution's real estate

lending activities;

•

The quality of management and internal controls;

•

The size and expertise of the lending and

administrative staff; and

•

Market conditions.

The institution should not be considered in nonconformance

of the standards as a result of minor exceptions or

inconsistencies

The size and financial condition of the institution;

•

The nature and scope of the institution's real estate

lending activities;

•

The quality of management and internal controls;

•

The size and expertise of the lending and

administrative staff; and

•

Market conditions.

The institution should not be considered in nonconformance

of the standards as a result of minor exceptions or

inconsistencies. Rather, examiners are to assess

management’s overall practices and performance when

assessing conformance with the standards.

Examination procedures for various real estate loan

categories are included in the ED Modules.

Commercial Real Estate Loans

These loans comprise a major portion of many banks' loan

portfolios. When problems exist in the real estate markets

that the institution is servicing, it is necessary for examiners

to devote additional time to the review and evaluation of

loans in these markets.

There are several warning signs that real estate markets or

projects are experiencing problems that may result in real

estate values decreasing from original appraisals or

projections. Adverse economic developments and/or an

overbuilt market can cause real estate projects and loans to

become troubled. Signs of troubled real estate markets or

projects include, but are not limited to:

•

Rent concessions or sales discounts resulting in cash

flow below the level projected in the original

appraisal.

•

Changes in concept or plan: for example, a

condominium project converting to an apartment

project.

•

Construction delays resulting in cost overruns, which

may require renegotiation of loan terms.

•

Slow leasing or lack of sustained sales activity and/or

increasing cancellations, which may result in

protracted repayment or default.

•

Lack of any sound feasibility study or analysis.

•

Periodic construction draws that exceed the amount

needed to cover construction costs and related

overhead expenses.

•

Identified problem credits, past due and non-accrual

loans

ire renegotiation of loan terms.

•

Slow leasing or lack of sustained sales activity and/or

increasing cancellations, which may result in

protracted repayment or default.

•

Lack of any sound feasibility study or analysis.

•

Periodic construction draws that exceed the amount

needed to cover construction costs and related

overhead expenses.

•

Identified problem credits, past due and non-accrual

loans.

Real Estate Construction Loans

A well-underwritten construction loan is used to construct a

particular project within a specified period of time and

should be controlled by supervised disbursement of a

predetermined sum of money. It is generally secured by a

first mortgage or deed of trust and backed by a purchase or

takeout agreement from a financially responsible permanent

lender. Construction loans are vulnerable to a wide variety

of risks. The major risk arises from the necessity to

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Federal Deposit Insurance Corporation

complete projects within specified cost and time limits. The

risk inherent in construction lending can be limited by

establishing policies which specify type and extent of

institution involvement. Such policies generally define

procedures for controlling disbursements and collateral

margins and assuring timely completion of the projects and

repayment of the institution's loans.

Before entering a construction loan agreement, it is

appropriate for the institution to investigate the character,

expertise, and financial standing of all related parties.

Documentation files would then include background

information concerning reputation, work and credit

experience, and financial statements. Such documentation

indicates that the developer, contractor, and subcontractors

have demonstrated the capacity to successfully complete the

type of project to be undertaken

stigate the character,

expertise, and financial standing of all related parties.

Documentation files would then include background

information concerning reputation, work and credit

experience, and financial statements. Such documentation

indicates that the developer, contractor, and subcontractors

have demonstrated the capacity to successfully complete the

type of project to be undertaken. The appraisal techniques

used to value a proposed construction project are essentially

the same as those used for other types of real estate. The

institution should realize that appraised collateral values are

not usually met until funds are advanced and improvements

made.

The institution, the builder, and the property owner typically

join in a written building loan agreement that specifies the

performance of each party during the entire course of

construction. Loan funds are generally disbursed based

upon either a standard payment plan or a progress payment

plan. The standard payment plan is normally used for

residential and smaller commercial construction loans and

utilizes a pre-established schedule for fixed payments at the

end of each specified stage of construction. The progress

payment plan is normally used for larger, more complex,

building projects. The plan is generally based upon monthly

disbursements totaling 90 percent of the value with 10

percent held back until the project is completed.

Although many credits advanced for real estate acquisition,

development or construction are properly considered loans

secured by real estate, other such credits are, in economic

substance, "investments in real estate ventures.” A key

feature of these transactions is that the institution as lend

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