3 Reasons for the Execution of Loan Participations

Loan participations are an integral tool of the financial services industry.

In a loan participation, one bank (originating institution) will originate a large (typically commercial) loan and for one reason or another, will “sell” a piece of that loan to another (or several other) bank participant(s). The reasons for the originating institution selling a piece, or the entire amount, of a loan can vary; however, some typical reasons for the execution of a loan participation are the following:

  1. Liquidity – An originating institution may sell a piece, or 100 percent, of a loan to generate cash to fund additional lending or other investment activities.
  2. Legal Lending Limit – All U.S. institutions are restricted on the amount of credit that it may extend to a single borrower (or group of borrowers). An originating institution may execute a participation agreement to remain under its respective legal lending limit.
  3. Other Regulatory Requirements – Regulation governs extensions of credit to officers and directors of a financial institution. In order to avoid violation of the provisions of this regulation, an institution may sell a piece or all of a loan.

Importance of Proper Reviews

Whatever the reason(s) for a participation agreement, both the originating and participating institutions should perform a thorough review of each provision within the agreement. In addition, each institution should have legal counsel and accounting personnel (either the internal accounting personnel or an external consultant) read the agreement. From a legal standpoint, each institution wants to ensure that the provisions of the agreement are not excessively favorable to one side or the other.

For example, each institution should be aware of the costs that will be incurred in the event of default of the borrower, including how such costs will be divided between the participating parties. In relation to accounting, it is particularly important that the originating institution analyze the agreement for compliance with the applicable accounting guidance that dictates qualification for sales treatment. Provisions that provide the originating institution with the ability to maintain effective control over the transferred asset (e.g. restrictions on the participating institution’s ability to sell or sub-participate the loan; call features) may result in the disqualification of sales treatment.

Take Care as You Manage Participation Agreements

Financial institutions are funding loans at a rapid pace and many will have to enter into participation agreements to fund further growth or avoid regulatory violations. Those institutions need to ensure that their participation agreements contain the appropriate provisions, and exclude any inappropriate language, in order to effectively execute the loan sales.

It is important that banks have proper review processes in place to avoid entering into poorly structured participation agreements. In addition, a document management software application (such as AccuAccount) can help your institution organize and manage participation agreements.

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