The work of the Basel Committee on Banking Supervision continues to portend changes for U.S. banking. This Committee, which is part of the Basel-based Bank for International Settlements, proposed last year that national banking supervisors upgrade their own procedures for assuring that banks adequately employ enhanced internal risk assessment techniques, particularly in their loan portfolios, as inputs to the capital calculation process.

With that in mind, the four federal bank supervisory agencies have proposed a new system of loan classification to more accurately reflect potential risk. The proposed structure replaces one that basically has been in place since 1938 with some revisions since then. The new proposal is clearly an overhaul, not a significant revision, and therefore requires significant analysis by individual banks but also by a bank’s legal function because of the proposal’s implicit mandates in the area of the documentation and supervision of loan credits. A summary of these proposals is set forth below.

The proposals divide the traditional risk assessment on a commercial loan into separate analyses: The first addresses the borrower’s capacity to meet its financial obligations and the second focuses on the nature of the loan facility and estimated loss severity. The ultimate category to which a particular credit is assigned is intended to be a reflection of both analyses, considered separately, so as to take into account not only the borrower’s weaknesses but also mitigating factors such as the nature and value of collateral and third party guarantees. Thus, the proposed new system permits a reconciling of different types of facilities and loss expectations so as to determine whether the asset will be criticized or classified.

The new borrower ratings are “marginal, “weak” and “default.” A “marginal” borrower exhibits potential weaknesses brought on by the threat of negative specific business or market trends. A “weak” borrower already is experiencing credit weaknesses that adversely affect the borrower’s ability to meet its obligations and would be reflected in adverse financial ratios, deterioration in operating performance, adversity in the borrower’s business that it cannot withstand or denial of access to the capital markets. A “default” borrower is one that the bank already has reported as being on non-accrual, partially charged-off or written down on its books or identified as being impaired. It does not, however, imply that the borrower’s circumstances warrant the triggering of a contractual event of default.

The new facility ratings range from “remote risk of loss” through “low,” “moderate” and “high” categories of estimated loss severity. Banks are free to adapt their own internal procedures so as to reflect “remote risk of loss” even in those cases where the borrower is rated “marginal” or “weak.” However, a loss severity estimate of  "low,” “moderate” or “high” means that the borrower already is rated “default.” The proposed rules contain guidance on the circumstances in which a “loss” asset should be fully or partially written off on the bank’s books even though the bank might expect that eventually it will be partially or fully repaid.

The key to justifying a credit as “remote risk of loss” is demonstrable evidence that in the event of default, management of the bank can liquidate the collateral it holds after taking into account any relevant margin to cushion potential fluctuations in the value of the collateral. This most often will involve collateral items such as securities, commodities and the like. At the same time, the proposed new rules take note of the fact that some credits are structured as self-liquidating and therefore can be viewed as involving a “remote risk of loss.” Examples of this type of credit would be agricultural loans, which are made to finance a particular production cycle, or film financing loans, which for the most part are intended to be repaid from the proceeds of the film’s distribution usually handled by independent third parties.

The proposed rules also treat asset-based lending (“ABL”) separately and permit a bank to treat specific types of loans, such as debtor-in-possession loans, as a “remote risk of loss” if the bank can demonstrate that the loan is “well-secured by highly liquid collateral” and the loan agreements and the conduct of the Bank show that it has strong control over the collateral and the facility in question. This special category includes accounts receivable and other working capital lending facilities that readily generate cash resulting from the conversion of the collateral. However, these two requirements will force a bank to examine both its existing documentation and its ability to exercise daily supervision of the facility.

For an ABL credit to pass as “remote risk of loss” certain standards have to be met: (1) The bank is able to liquidate the collateral for cash within 90 days of a loan default; (2) The loan is “substantially” over-collateralized to assure full recovery, with valuations of the collateral no older than 60 days; and (3) The collateral is under the bank’s “control” through active credit management involving “disbursement practices and collateral controls.” These requirements may challenge the manner in which some banks currently treat their existing ABL portfolios.

The proposal also addresses the benchmarks of “criticized assets” and “classified assets.” The former is all loans to borrowers rated “marginal” (excluding facilities, wholly or partially rated “remote risk of loss”) plus ABL loans to borrowers rated “weak” where the facility is rated “low loss severity.” The latter category covers all loans to borrowers rated “default” (excluding facilities, in whole or in part, rated “remote risk of loss”) plus all loans to borrowers rated “weak,” other than those (or portions) rated “remote risk of loss” and ABL loans rated “low loss severity.”

Special note is taken of guarantees in the proposed new rules. An unconditional guaranty permits the bank to substitute the rating of the guarantor for that of the borrower in determining whether a credit is to be “criticized” or “classified.”

As might be expected, the banking regulators will carefully scrutinize collateralized loans where the facilities are in excess of the underlying collateral’s real net realizable values.

The proposals also contain a number of examples demonstrating the manner in which the new system is intended to operate. The bank regulatory agencies invite comments on the proposals by June 30, 2005, particularly about how these rules might impact their credit and risk assessment procedures, including additional implementation and training costs and the time anticipated to effectively implement the proposed rules. It is anticipated that after adoption, there will be a significant transition period to allow banks to adapt their procedures accordingly.

See, 70 Federal Register No. 58 at page 15681, March 28, 2005, referred to in OCC Bulletin 2005-8.

Harold P. Reichwald  is a highly experienced business attorney whose career encompasses domestic and international matters, including privatization projects involving telecommunications. He has represented lenders in a wide variety of transactions throughout his carrier including, specialized lending work utilizing bankruptcy remote entities and other special purpose vehicles. Mr. Reichwald's financial institutions experience comprises a broad range of matters including: sophisticated financial transactions such as asset securitization, LBOs, project finance, corporate lending and restructuring; representations of a variety of domestic and foreign financial institutions before the FDIC, Comptroller of the Currency, the Federal Reserve Board and other bank regulatory agencies in connection with new product development, chartering new banks and branches, issues arising out of the bank examination process and enforcement actions demanded by regulatory authorities.