District Circular Letters

April 23, 2001

BANKING SUPERVISION AND REGULATION:
RISK MANAGEMENT PRACTICES FOR
LEVERAGED FINANCING

To State Member Banks, Bank
Holding Companies, U.S. Branches
and Agencies of Foreign Banks,
and Others Concerned,
In the Twelfth Federal Reserve District

Sound Credit Risk Management Practices (SR 01-9 [SUP])

On April 9, 2001, the Federal Reserve, along with the other federal banking agencies, issued a Guidance that addresses sound risk management practices for institutions engaged in leveraged financing. This guidance augments previously issued supervisory statements on sound credit risk management.

Leveraged financing has been an important financing vehicle for mergers and acquisitions, business recapitalizations, and business expansions. These transactions are characterized by a degree of financial leverage that significantly exceeds industry norms as measured by various debt, cash flow, or other ratios. Consequently, leveraged borrowers generally have a diminished ability to respond to changing economic conditions or unexpected events, creating significant implications for an institution's overall credit risk exposure and challenges for bank risk management systems.

Over the past year, deterioration has emerged in leveraged finance portfolios of many banking organizations, driven in part by the relaxation of sound lending standards in past years. In response, affected institutions have strengthened their lending standards and are amending their risk management practices. The purpose of the guidance is to clarify supervisors' expectations regarding sound practices and to facilitate their adoption.

Leveraged finance activities can be conducted in a safe and sound fashion if pursued with a risk management structure that provides for appropriate underwriting, pricing, monitoring, and controls. The interagency guidance highlights the need for comprehensive credit analysis processes, frequent monitoring, and detailed portfolio reports to better understand and manage the inherent risk in these leveraged finance portfolios.

Many leveraged transactions are underwritten with reliance on the imputed value of a business (enterprise value), which often exhibits a high degree of volatility. The guidance stresses the importance of sound valuation methodologies and ongoing stress testing and monitoring of enterprise values. The statement also provides guidance about risk rating leveraged finance loans and how enterprise value should be evaluated in the risk rating process.

Copies

All supervision and regulation letters and attachments are available for viewing and printing on the Board’s Internet website, at http://www.federalreserve.gov/boarddocs/SRLETTERS/.

Copies of the Guidance are available from our Corporate Services Department. To request copies to be sent by mail, please call (415) 974-2060.

Additional Information

For additional information about risk management practices for leveraged financing, please contact our Banking Supervision and Regulation Department, at (213) 683-2738.

FEDERAL RESERVE BANK OF SAN FRANCISCO