On November 6, 2015, the Federal Deposit Insurance Company (FDIC) issued its Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations (FIL-49-2015) (FIL), which stressed the importance of banks implementing strong underwriting, effective due diligence and prudent credit risk management practices when purchasing and participating in loans, especially loans from nonbank third-party lenders, such as Prosper and Lending Club.
The number of loans originated by these non-bank third parties has been growing rapidly in recent years. At the same time, and partly because of the non-bank third-party lenders, it has become more difficult for some banks to compete in the consumer and small business lending markets. One way for banks to stay involved in these markets is by purchasing and participating in loans originated by these non-bank lenders. However, an increasing number of banks have been over-relying on lead institutions’ diligence findings or on third-party arrangements, including unsecured loans or loans underwritten using proprietary models that limit the bank’s ability to assess factors such as underwriting quality and credit quality. In some instances, such over reliance by banks has caused significant credit losses and contributed to bank failures.
The FDIC seems to understand the importance of refraining from making banks’ participation in these non-bank-originated loans too cumbersome with its sentiment in the FIL that the “FDIC strongly supports banks’ efforts to prudently meet the credit needs of their communities.” However, the FDIC advises banks to become more involved with these loans on the front end, similar to the way a bank would if it were originating the loans. Becoming more involved would include, for example, understanding the loan type, the borrower’s market and industry and the credit models relied upon to make the credit decisions, as well as managing third-party arrangements with an effective third-party risk management process.
Prior to purchasing a loan or participating in a loan, banks should perform the following steps:
- Ensure loan policies include and address purchased and participation loans and set clear underwriting guidelines.
- Perform the same degree of credit and collateral analysis as if it were the originating bank.
- In purchases or participations involving an out-of-territory loan or borrower, and in situations involving a third-party relationship, banks should complete extensive diligence to try to discover and manage the risks involved.
- Enter into a written loan sale or participation agreement that fully and clearly describes the roles of all parties and establishes requirements for obtaining specific information.
- Ensure that prior approvals from the board, or an appropriate committee, are obtained as necessary and that all reports to the board provide a sufficient account of the activity, performance, and risk of purchased loans and participations.
While some of these practices may be too burdensome, some should, at the very least, help a few banks change some of their ways and avoid a massive catastrophe in the future. However, it will remain to be seen whether the FDIC’s guidance and recommended practices make purchasing or participating in a loan more cumbersome and less appealing to banks, or if these practices will help banks implement better practices in the future for purchasing and participating in loans.