The Definition of Leveraged Lending

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1 The Definition of Leveraged Lending Definitional Expectations for Financial Institutions Under the Final Guidance Leveraged Lending The March 2013 Interagency Guidance on Leveraged Lending ( Guidance or Guidelines ) reinforced the need for financial institutions to adopt their own appropriate definition of leverage lending and identified certain commonly used industry factors that should be considered when defining it: Loans where the proceeds are used for buyouts, acquisitions, or capital distributions; Transactions where the borrower s Total Debt/EBITDA exceeds 4.0X or Senior Debt/EBITDA exceeds 3.0X, or these measures exceed other defined levels appropriate to the industry or sector; Loans where the borrower is recognized to be a highly leveraged firm in the debt markets based on a High Debt/Net Worth ratio; and Transactions that leave a borrower s post-financing leverage significantly exceeding industry norms or historical levels, as measured by the borrower s leverage ratios (e.g., Debt/Assets, Debt/Net Worth, Debt/ Cash Flow, or other similar standards common to particular industries or sectors). A financial institution engaging in leveraged lending should define it within its policies and procedures in a manner sufficiently detailed to ensure consistent application across all business lines. The definition should: Clearly describe the purposes and financial characteristics common to these transactions and Cover risk to the institution from both direct and indirect exposure via limited recourse financing secured by leveraged loans, or financing extended to financial intermediaries (such as conduits and special purpose entities (SPES)) that hold leveraged loans. The Final Guidelines noted that the leveraged lending designation is typically made at loan origination, modification, extension, or refinancing. Fallen angels or borrowers that have exhibited a significant deterioration in financial performance after loan inception and subsequently become highly leveraged would not be included within the Guidance s scope, unless the credit is modified, extended, or refinanced.

2 The Risk Management Framework Management and the Board should identify the risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes Policy Expectations for Financial Institutions Under the Final Guidance A financial institution s credit policies and procedures for leveraged lending should address the following: Identification of a risk appetite that includes clearly defined amounts of leveraged lending that the institution is willing to underwrite (e.g., pipeline limits) and is willing to retain (e.g., transaction and aggregate hold levels). The risk appetite should be supported by an analysis of the potential effect on earnings, capital, liquidity, and other risks that result from these positions, and should be approved by its Board; A limit framework that includes limits or guidelines for single obligors and transactions, aggregate hold portfolio, aggregate pipeline exposure, and industry and geographic concentrations. The limit framework should identify the related management approval authorities and exception tracking provisions. In addition to notional pipeline limits, financial institutions with significant leveraged transactions should implement underwriting limit frameworks that assess stress losses, flex terms, economic capital usage, and earnings at risk, or that otherwise provide a more nuanced view of potential risk; Procedures for ensuring the risks of leveraged lending activities are appropriately reflected in an institution s allowance for loan and lease losses (ALLL) and capital adequacy analyses; Credit and underwriting approval authorities, including the procedures for approving and documenting changes to approved transaction structures and terms; Guidelines for appropriate oversight by Senior Management, including adequate and timely reporting to the Board; Expected risk-adjusted returns for leveraged transactions; Minimum underwriting standards; and Effective underwriting practices for primary loan origination and secondary loan acquisition.

3 Supervisory Expectations Related to Safe and Sound Leveraged Lending Activities The Final Guidelines identified certain principles related to safe and sound practices, including: Principle Participations Purchased Underwriting Standards Valuation Standards Expectations for Financial Institutions Under the Final Guidance An institution that participates in leveraged loans should make a full and independent evaluation of transaction and its risks prior to committing funds and establish underwriting and monitoring standards similar to loans underwritten internally Underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower's capital structure is sustainable, regardless of whether the transaction is underwritten to hold or distribute Valuation standards should concentrate on the importance of sound methods in the determination and periodic revalidation of enterprise value and should be performed by qualified persons independent of an institution s origination function Pipeline Management An institution should be able to accurately measure exposure on a timely basis, establish policies and procedures that address failed transactions and general market disruptions, and ensure periodic stress tests of exposures to loans not yet distributed to buyers Reporting and Analytics Management information systems should accurately capture key obligor characteristics and aggregate them across business lines and legal entities on a timely basis that includes at least quarterly reporting to Management and periodic reporting to the Board

4 Supervisory Expectations Related to Safe and Sound Leveraged Lending Activities, cont. Principle Expectations for Financial Institutions Under the Final Guidance Risk Rating Leveraged Loans Risk rating standards should consider the use of realistic repayment assumptions to determine a borrower's ability to de-lever to a sustainable level within a reasonable period of time Credit Analysis Problem Credit Management Policies should address the need for a comprehensive assessment of financial, business, industry, and management risks that include analyses and projections employed during the approval process as well as ongoing monitoring Credit policies and individual action plans should be formulated to define expectations when working with borrowers experiencing significant plan variances, such as diminished operating cash flows and depreciated collateral values Deal Sponsors Guidelines should be developed for evaluating the qualifications of financial sponsors and should implement processes to regulatory monitor a sponsor s financial condition Credit Review An independent credit review function should be able to provide timely and accurate assessments of the leveraged portfolio as well as identify portfolio risks and escalate inappropriate risks and other findings to Management

5 Supervisory Expectations Related to Safe and Sound Leveraged Lending Activities, cont. Principle Expectations for Financial Institutions Under the Final Guidance Stress testing Stress testing should be performed on leveraged loans held in portfolio as well as those planned for distribution, in accordance with existing interagency issuances Conflicts of Interest Reputational Risk Compliance Appropriate policies, procedures, reporting, and employee training programs should be developed to address and prevent potential conflicts of interest when the financial institution has both equity and lending positions with a single borrower As leveraged lending transactions are often syndicated through the financial and institutional markets, failures to meet legal responsibilities in underwriting and distributing transactions or distributing transactions with subsequent significantly higher default/loss rates and performance issues may damage a financial institution s market reputation and impair its ability to compete An independent compliance function should periodically review the institution s leveraged lending activity in order to ensure potential conflicts are avoided, and laws and regulations are adhered to, including ensuring that its policies incorporate safeguards to prevent violations of anti-tying regulations and compliance with applicable securities laws

6 Hugh Kelly KPMG LLP Principal & U.S. Lead Partner for Bank Regulatory Advisory Hugh C. Kelly Principal & National Lead Partner Bank Regulatory Advisory KPMG LLP 1801 K Street, NW Washington, DC Tel Cell hckelly@kpmg.com Education, Licenses & Certifications Bachelor s degree in Finance from Loyola Marymount University, Los Angeles, CA Graduate of Pacific Coast Graduate Banking School; ABA International Banking School Commissioned National Bank Examiner Hugh is a KPMG U.S. Principal and the Lead National Partner for Bank Regulatory Advisory Services. He is the U.S. Co-Lead Partner for KPMG s Global Regulatory Center of Excellence and member of KPMG s Global Basel & Global FS Regulatory Steering Committees. Key responsibilities and accomplishments: Governance, Risk & Compliance: Lead partner on engagements assisting large systemically important financial institutions enhance governance, risk and compliance management frameworks, including risk culture, capital and liquidity planning, risk appetite process, operational risk management, third party risk oversight and internal audit processes. Conducts independent Get to Strong / Heightened Expectations assessments focused on meeting regulatory expectations, enhancing effectiveness and clarity of roles/responsibilities across the three lines of defense and promoting sustainability and effective challenge of the risk governance framework. Assists numerous bank and non-bank prepare for OCC and Federal Reserve examinations as well as effectively address regulatory matters ( i.e., MRA, MRIA, enforcement actions). Operational Risk Management and Third-Party Risk Management ) Industry leader in designing and implementing enhanced Risk & Control Self Assessment (RCSA) and Third-Party Risk Assessment frameworks to meet the heightened regulatory expectations and need for consistent risk intelligence to improve decision-making, reporting and practical integration with risk appetite. Leading driver for KPMG International being been named Best Overall Consultancy by Operational Risk and Regulation magazine, whose annual awards recognize companies that demonstrate innovative thinking and provide useful solutions to the operational risk management challenges faced by the financial services industry. Led KPMG/RMA s Operational Risk Management Excellence - Get to Strong Survey of large financial institutions to provide benchmarking intelligence on leading industry ORM practices in support of enhanced business value, heightened regulatory expectations for strong risk management and Basel AMA use test requirements. Led KPMG s assistance to BITS and The Financial Services Roundtable on a study on Reconciliation of Regulatory Overlap for Management and Supervision of Operational Risk in U.S. Banks, which identified overlapping regulatory compliance requirements in SOX 404, FDICIA, GLBA 501b and the Basel II AMA Guidance for Operational Risk Management. (continued)

7 Hugh Kelly KPMG LLP Principal & U.S. Lead Partner for Bank Regulatory Advisory (continued) Bank/BHC Charters/Licenses, IHC and Cross-Border Regulatory Challenges: Assists numerous U.S. and foreign institutions apply for and establish US branch and bank licenses, plan for and implement legal entity and governance frameworks for an Intermediate Holding Company (IHC) under Section Enhanced Prudential Standards and Early Remediation Requirements for FBO s, including focus on risk appetite, risk culture, credible challenge, regulatory reporting, and Regulation W compliance Co-leader of KPMG s Global Regulatory Center of Excellence (COE), which is focused on providing clients with timely and insightful thought leadership on emerging global regulatory developments and challenges. Assists numerous global financial institutions manage cross-border home-host regulatory challenges. Member of the Institute of International Finance s (IIF) Effective Supervision Advisory Group and Shadow Banking Working Group. Active speaker and participant in international regulatory groups and fora sponsored by the IIF, Group of 30, Institute of Institutional Bankers (IIB), Risk Management Association (RMA), The Clearing House, BITS, ORX, etc. Prior to joining KPMG in 2004, Hugh had a 26 year career with the U.S. Office of the Comptroller of the Currency (OCC). Key responsibilities and accomplishments: Hugh joined the OCC in 1997 and commissioned a national bank examiner in He examined complex community, regional and money center banks from the OCC s Los Angeles Office, until he was assigned in 1985 to the OCC s London Office to examine European operations of large U.S. national banks. From , Hugh was a lead capital markets specialist, the Executive Assistant to the Senior Deputy Comptroller for Bank Supervision in Washington, DC, the Large Bank Examiner-in-Charge at Mellon Bank, First Chicago and First Chicago NBD, and led domestic and international examinations at numerous large national banks, including Bank of America, Bank of Boston, Banc One, Chase Manhattan, Citibank, Continental Illinois, Nations Bank, Norwest, Security Pacific, and Wells Fargo. From , Hugh was the Senior Advisor for Global Banking and Head of the Global Banking Division responsible for formulating the OCC s supervisory plans for emerging global risks affecting U.S. large banks. During this time, Hugh was: OCC representative in multilateral supervisory coordination efforts with U.S. and foreign regulators, including the Basel Committee on Banking Supervision (BCBS). Member of U.S. and global bank supervisory groups, including the FFIEC IT Technology Working Group; U.S. Interagency Critical Infrastructure Working Group; U.S. Interagency Country Exposure Review Committee (ICERC); Shared National Credit (SNC) Program; Association of Supervisors of Banks of the Americas (ASBA); Asia-Pacific Economic Cooperation (APEC) Bank Supervisors Committee; Caribbean Group of Banking Supervisors (CGBS); President s Council on Y2K; Global 2000 Coordinating Committee; IIF; Group of 30; IIB; FSR/BITS; and RMA Operational Risk Management Discussion Group. Member of the OCC s National Risk Committee, Large Bank Supervision Management Team, and Basel Capital Policy Task Force. Co-leader in the development of OCC and Inter-agency policy implementing the Basel II Operational Risk Advanced Measurement Approach (AMA), and supervisory guidance on third party risk management and off-shoring, Internet banking, IT risk management, GLBA 501 information security programs, country risk management, capital markets and foreign exchange trading.