On March 22, 2013, the US federal banking agencies (the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) published interagency guidance on how to engage in leveraged lending activities in a safe and sound manner.

Since then, the banking agencies have received numerous   inquiries from the banking industry on how to comply with the Interagency Guidance. On November 7, 2014, the banking agencies issued answers to “Frequently Asked Questions” that the agencies said were designed to foster better understanding of the Interagency Guidance and the agencies’ expectations on industry compliance.

According to the Interagency Guidance, a determination of whether a loan qualifies as “leveraged lending,” typically is made at the time that the loan is originated, modified, extended or refinanced. What exemplifies  a loan as leveraged usually is some combination of the following characteristics:

  1. the proceeds of the loan are used for buyouts, acquisitions or capital distributions;
  2. transactions:
    1. where the borrower’s total debt divided by EBITDA (earnings before interest, taxes, depreciation, and amortization) exceeds four times EBITDA or
    2. where the borrower’s senior debt divided by EBITDA exceeds three times EBITDA, or
    3. where the borrower’s total debt or senior debt exceeds other defined levels considered “appropriate to the industry or the sector;”
  3. A borrower recognized in the debt markets as a highly leveraged firm, characterized by a high debt to-net-worth ratio; and
  4. 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 must have policies and procedures in place that address, among other issues, identification of the institution’s risk appetite for such lending; underwriting  limits on and minimum standards regarding such lending; appropriate oversight by senior management; and effective underwriting practices for loan origination as well as purchases in the secondary market.

The 26 questions cover a wide variety of topics, including leveraged loan identification, loan originations, loan risk ratings, use of nonbanking subsidiaries to make such loans, purchases and sales of leveraged loans in the secondary market, and regulators’ assessment of a financial institution’s compliance with the Interagency Guidance.