Considering Loan Participations for your financial institution? Not sure what they even are? Want to learn the pros and cons? Curious about the process for setting them up? You’re in the right place.
This article will give a basic introduction, review the possible perks and pitfalls, and cover what’s involved to buy or sell loan participations at your financial institution.
The 2020 Banking and Capital Markets Outlook from Deloitte Insights points out a range of disruptive changes for today’s financial institutions. From technology demands to changes in a COVID-19-affected world, it’s a lot.
Their advice: Over the next decade, “banks should remain true to their core identity as financial intermediaries, matching demand with supply of capital.”
Banks and credit unions must continue to effectively manage risk and complex financial matters, according to Deloitte’s analysis. Loan participations are one tool you have to mitigate risk and ensure a flow of capital to your customers.
How do both the originating and participating institutions benefit?
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What are Loan Participations?
First, let’s get on the same page on what they even are. Loan participations are “an instrument that allows multiple lenders to participate or share in the funding of a loan.”
This can help lenders mitigate risk. Additionally, participations can allow your institution to diversify balance sheets while increasing revenue and liquidity.
There are three primary kinds, each varying in ownership and responsibility.
- Participation: In this loan participation arrangement, the loan is underwritten and closed by a lead financial institution. Then, that bank or credit union subsequently sells portions of the loan to other financial institutions.
- Syndication: “Multiple lenders coming together to fund a large loan for a single borrower”, according to Avana Capital.
- Assignment: The original lender transfers rights and obligations to the purchasing financial institution. In this structure, risk moves as well.
For the first two types, participants reap the rewards of interest earned. However, all parties share the risks if the borrower defaults. In a syndicate, the goal can be to facilitate a loan that’s larger or more risky than any single institution can handle.
Some loan participations have a third-party handle loan servicing. There are also many software platforms that integrate with your core system to facilitate the process.
Loan participation notes are considered fixed income securities. Upon maturity of a loan, there is a complete return of principal, with interest arriving through fixed periodic payments. Auto loans and mortgages are the most common loans in these portfolios.
Pros of Loan Participations
Loan participations can be a win for both sellers and buyers. Otherwise, why would they exist? The specific benefits depend on your institution size and goals.
For larger institutions, loan participations can help reduce credit risk, increase capital, and obtain liquidity. This lets them take advantage of new lending opportunities. In this case, they are the lead financial institution selling loans (or portions of) to others.
A smaller institution, or one in a slow-growth market, may approach loan participations from the other side. For them, it can empower investment in a strong deposit base with higher yielding assets, while reducing geographic-associated risks.
They would be receiving the loans from other lenders. Of course, a small or slow-growth market institution can be the lead, while a larger institution may be the buyer.
Here’s a benefit summary of loan participations from both perspectives:
- Take advantage of profit sharing. Buying loan participations allows you to share in the profits of the lead bank. Your institution can reap the revenues of a strong lending market, even if your own is currently slow.
- Diversify your assets. Reduce risk by investing in a variety of loans from a range of geographic areas. This diversification minimizes exposure to potential losses in your service area from economic downturns or natural disasters. Essentially, being able to “weather storms” to serve your local base.
- Manage regulatory limits. Loan participations open the possibility to funding unusually large loans you may otherwise be legally prohibited from servicing.
- Reduce lending risk. Distributing risk among multiple institutions is helpful to banks or credit unions that may be in a community with a higher than average rate of delinquency. This lets you continue lending at affordable rates.
- Maintain profitable customer relationships. Have a large-scale borrower? Selling loan participations lets you stay “the institution of record” for them, retaining the lead role in their relationship.
Cons of Loan Participations
After talking about all the benefits of loan participations, we promised an honest discussion of its possible downfalls. The following section covers reasons why you may not wish to participate in loan participations.
Or, if you do, be aware of these potential issues ahead of time.
Complexity & Regulatory Attention
As with any investment, caution is essential. Loan participations “have numerous advantages but are complex and attract regulatory attention,” notes a CUNA Lending Council white paper.
“They need to be ‘done right’ to work, and require quality partners and resources or access to those resources.” Increased complexity and greater regulatory scrutiny are just two of the downsides of loan participations.
Loan participations can involve greater risk than traditional lending. Wait, what?
“Reducing risk” is a potential benefit of the process. That is true. It can help you spread out risk, so in the event of default, your institution shares that financial hit. And, of course, the larger the loan, the heavier the possible losses.
Another risk is that other institutions may offer their more risky loans for participation. Perform strong due diligence ahead of time to avoid this situation, unless your goal is to increase risk for a portion of your portfolio, at the possible benefit of stronger returns.
Even if the loans are solid, you may have less data on the performance. That’s where you need to ensure detailed and consistent monthly participation reports.
Just like your lending policies, it’s up to your institution to decide the degree of acceptable risk for the program.
Terms & Red Flags
Loan participation agreements can bring their own share of negatives. Of course, good due diligence will illuminate any issues ahead of time. For example, ensure the agreement is based on pro rata, meaning each participant has an equal share.
In this arrangement, all cash flows should be divided equally, with all parties having the same priority.
When reviewing a loan participation agreement, look for these red flags:
- Purchasing institution’s interest rate differs from contractual loan rate: Sometimes a lead bank will structure it in this way to gain some compensation for servicing the loan. While there are ways to justify loan servicing compensation, this approach will cause cash flows to be disproportionate.
- Allowance for lead FI to repurchase the participated portion of the loan: Instead, include a “right of first refusal” provision.
- Requirement that participants obtain permission before selling their interest in the loan: This gives the lead bank unequal control.
What’s the Process for Setting Up Loan Participations?
Thinking of hosting or joining a loan participation? The process differs whether you are a buyer or a seller. We’ll approach it from both perspectives.
- Put loan participation policy in place: This policy will prepare you for the buying process. Include underwriting standards and parameters on purchases, loan types, and amounts.
- Get familiar with the market: Sign up for notifications of loan participation offerings. Seller institutions often provide notifications of offerings to existing partners.
- Evaluate offerings: If you find an attractive loan participation opportunity, you’ll need to sign a confidentiality agreement to see the seller’s due diligence package.
- Review sample files: Once an agreement is signed, you can have access to a sample of files from the loan pool.
- Perform due diligence: Here’s where you can reduce risks and ensure your institution is protected to the greatest extent possible. It’s also when you’re able to decide if the opportunity makes sense for your institution. Share concerns and request arrangement modifications.
- Close on loan: You’ll receive an updated balance of each loan at closing. Sign the master agreement, and the seller will receive funds.
- Receive payments: Your institution will start receiving prorated principal and interest payments each month. The monthly payment will have a servicing fee deducted.
Sellers have two options for initiating a loan participation. They may set it up internally, which can be a complex process.
Another option is to use a third-party, which manages the buying, selling, and servicing process. Whether you do it yourself or use a third-party, selling will involve:
- Establishing a loan participation policy
- Organizing portfolio data for potential buyers
- Deciding on pricing
- Reaching out to your buyers network
The time and involvement of offering loan participations will depend on whether or not you involve a third-party. Sellers are responsible for providing monthly trial balance reports, delinquency reports and other applicable statements.
A third-party servicer handles all necessary forms, policies, distributions, and reporting.
Whether the buyer or seller, there can be costs to loan participations. As a buyer, you have the option of managing in-house or through a third-party servicer. Both options have costs.
For in-house, consider needed staff time, additional training, reporting obligations, and possible software licensing and integration costs.
Third-party servicers handle all necessary steps, and charge by deducting a fee before distributing monthly payments.
Additionally, consider consulting fees. It’s recommended that both buyers and sellers get expert opinions from accountants and lawyers before signing agreements.
Important: For both buyers and sellers, loan participations are not a “set it and forget it” investment. Regular reviews to assess risk, as well as close communication with the lead bank is necessary to ensure smooth operation.
Deciding If Loan Participations Are Right For Your Institution
So, are loan participations right for your institution? That’s for you to decide. Here’s a summary of the factors you can consider:
- Investment goals: Are you looking to increase income through calculated risk investment strategies?
- Loan income: Are your loans not bringing in desired income? Or, is your servicing area below regional or national averages in volume or risk?
- Growth: Is your institution looking to grow without expanding service area or population?
- Willingness to learn: Loan participations may be a new direction for your institution. Ensure you’re ready for the effort involved in learning and implementation.
- Regulatory awareness: Attention from your regulator won’t decrease with loan participations. Is the reward worth the additional costs of compliance?
As you can see, it’s not a simple yes or no. Take some time, do your research, and discuss with your team the benefits and downsides for your specific institution.
Investment Practices are Just the Start
Banks and credit unions of all sizes embrace loan participations as part of a diverse investment portfolio. Consider guidance and recommendations from FDIC (the basics are close enough at a high level) to help decide whether to move forward at your institution.
Loan participations are a valuable tool in a highly competitive banking environment. Our goal is to help you recognize and understand the tools available, while sharing our insights so you can make sound investment decisions.
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