WASHINGTON — Reacting to deterioration in leveraged loan portfolios, federal bank and thrift regulators issued joint guidelines Monday outlining proper risk management practices for institutions making such loans.

Regulators have seen banks’ leveraged finance portfolios weaken recently, and they blame, at least in part, bankers for relaxing their standards during good economic times. Now that the economy has slowed, many leveraged borrowers are in shakier positions — and that has increased banks’ overall credit risk exposure.

Dave D. Gibbons, deputy comptroller for credit risk, noted that leveraged finance plays a key role in mergers and acquisitions, business recapitalizations, and business expansions. Regulators, he said, do not want bankers to shut off this form of credit. “Leveraged lending is not a bad thing — that’s not what we’re saying. In a lot of ways, leverage makes the world go round,” Mr. Gibbons said.

According to a joint release by the four agencies, the guidelines highlight “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.”

In the release, the agencies hinted at what their approach will be during the shared national credit exam this spring, when all $20 million-plus credits shared by three or more lenders will be rated. “In cases where a borrower’s condition or future prospects have significantly weakened, leveraged finance loans will likely merit a substandard or worse classification based on the existence of well-defined weaknesses,” the regulators said.

Allen Sanborn, president of the Risk Management Association, which represents lenders, said the guidelines are reasonable. “I think these are good, common-sense guidelines,” he said. “If bankers and regulators follow them closely, [the shared national credit exam] should be fine.”

Beginning around 1998, regulators noticed lenders were relaxing their standards for leveraged lending, Mr. Gibbons said. More institutions were entering in the business and examiners found the practice being conducted in the broader middle market. While regulators have no precise definition, a loan is considered leveraged when a borrower’s debt-to-equity ratio exceeds its industry’s average. Because no uniform definition exists, regulators cannot quantify these loans or say how many are troubled.

The guidelines suggest bank managers and boards should receive quarterly “comprehensive reports about the characteristics and trends” of the institution’s leveraged loans. Banks should set concentration limits, too, while senior-level managers institute and oversee policies on pricing and underwriting terms for leveraged loans.

The agencies noted that relying on a borrower’s enterprise value as a backup source of repayment “can be problematic” because it is so closely tied to the company’s cash flow, typically the primary repayment source. “Events or changes in business conditions that negatively affect a company’s cash flow will also negatively affect the value of the business, simultaneously eroding both the lender’s primary and secondary source of repayment,” the guidelines say. “Lenders … that utilize unrealistic assumptions to determine enterprise value are likely to approve unsound loans at origination or experience outside losses upon default.”


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