Key Elements to Loan Participations Purchased: Due Diligence and Documentation
By: Mike Jackson, Regional Manager-West
There has been a notable increase in participations purchased as financial institutions across the state of Kansas attempt to diversify the loan portfolio, and/or address the need to increase loan volume during periods of declining loan demand. Routinely, many of the participations purchased are from outside the bank's defined trade area and deviate from the expertise of the loan officers in the purchasing bank. This should not be interpreted to indicate that participations are "bad" or that bank management should not use them as a financial tool to address the needs of the bank. However, management must obtain the proper documentation to perform adequate due diligence before funds are advanced. Additionally, adequate documentation must be maintained to continually analyze the collateral coverage and repayment ability of the credit. While a general reliance on the credit analysis performed by the originating bank is typical, it is imperative that the purchasing bank also complete an independent analysis, ensuring the level of risk in the borrowing relationship is within the defined credit underwriting parameters of the bank.
The Board of Directors must provide daily management with the appropriate lending policies and procedures to ensure participations purchased are achieving desired goals, and are within the risk profile determined by the Board. At a minimum written policies should address: documentation requirements, types of credit preferred, acceptable trade areas, and loan officer limitations. Furthermore, the Board should ensure participation agreements clearly define the rights and responsibilities of both the buyer and the seller describing any recourse arrangements and the agreement by the originating bank to provide credit information on a continuing basis. Finally, the Board must ensure loan officers have the appropriate expertise to analyze the type of lending represented within the participations purchased.
As stated above, participations purchased are not "bad" and can be a very useful product if used appropriately. However, the fact remains there is risk involved any time funds are advanced. How management identifies, measures, and monitors the risk associated with participations will be the key to reducing losses and examiner criticism.
