Some community banks exploring ways to improve earnings given weak local loan demand have begun or returned to purchasing loan participations. The financial crisis highlighted several risky features of participations, including challenges to implementing effective workout plans and weaknesses in underwriting by the loan purchaser. In this context, we have seen an increase in participations purchased from so-called
platform lenders. Platform lenders use an online business model to extend both household and commercial credit to borrowers often funded
by individuals or banks. Platform lending raises risks associated with traditional participations and potentially raises additional risks too.
This article focuses on some of the risk management practices appropriate for the purchase of participations, including those from platform lenders. It closes with a discussion of additional risk considerations associated with platform lending.
Effective Risk Management Practices for Managing Loan Participations
Many of the risk management practices that apply to traditional loan participation activity also apply to platform lending. The following are among the most important:
Setting appropriate risk limits: A community bank’s board should develop appropriate risk limits prior to purchasing participations,1 including those originated by a platform lender. The board should be sure to consider long-term (through the economic and credit cycle) risks of the purchased portfolio when setting limits in order to effectively mitigate downside risk. An effective way to accomplish this is by setting participation limits based on capital levels rather than as a percentage of the loan portfolio (or segment). The board should consider setting limits on the following:
- The total volume of out-of-area participations, as they typically present underwriting and oversight challenges different from locally generated loans.
- The aggregate amount of loans purchased from (or serviced by) a single outside source to manage counterparty risk.
- The aggregate volume of loans in various geographies and to particular industries to manage concentration risk.
- The board is more able to include the purchased loan activity in strategic and capital planning if it establishes effective limits early.
Underwriting: Management should apply the underwriting standards it uses for loans the bank originates when it evaluates platform loans for purchase just as it should with other participations. In other words, the bank should perform independent due diligence, including critical analysis of repayment sources, borrower financial condition and collateral for each loan. Management should ask, “Would the bank make a similar loan at similar terms to a local borrower?”
Ongoing monitoring: Banks involved in purchasing participations, including from platform lenders, need to understand how they will monitor borrower financial conditions once the loan is originated. The bank should review purchased credits, whether platform loans or traditional participations, similar to other loans, including monitoring the borrower’s financial performance, appropriately risk-rating the loan and monitoring compliance with loan covenants.
Other Risk Considerations Associated with Platform Lending
The first step for a bank considering entering into an agreement to purchase loans from a platform lender is to understand the risks that may be associated with the activity as outlined in the contract with the originator. Some questions about risks that banks should ask include the following:
- Credit risk: If a credit scoring model is used by the platform lender to underwrite the loans, is the model based on sound underwriting practices, and does the bank have access to the model’s algorithms to ensure that the model is consistent with the bank’s risk appetite?
- Compliance risk: What compliance risks arise from platform loan purchases? The nature of potential compliance risk depends on the structure of the relationship between the platform business and the bank as well as on the transactions themselves. For example, the bank must assure itself that any credit scoring model used does not rely on impermissible factors or result in fair lending concerns. Further, the bank should consider compliance considerations if there is a substantial difference between the rate paid to the platform lender by the underlying borrower and the rate the bank receives from purchasing the loans. Finally, the bank should ensure that the lender is meeting applicable disclosure requirements and complying with relevant state or federal laws.
- Vendor management risk: What vendor management does the bank need to engage in? An effective vendor management program has many features including, but not limited to, underwriting and monitoring the financial condition of the originator/servicer. Further, the bank should understand how the vendor will comply with information security requirements.
- Accounting risk: The bank should assess whether the purchases qualify as a true sale and how this determination affects the legal lending limit for the loans purchased. For example, will all loans purchased from a single platform be combined when determining if the bank conforms to lending limits?
Purchasing participations can be an appropriate strategy for community banks to increase earnings; however, an effective program must include strong governance, underwriting and ongoing monitoring systems. Management must consider all risks, including those posed by the originator and servicer.