BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D. C.  20551
			DIVISION OF BANKING SUPERVISION AND REGULATION
			SR 01-9 (SUP) April 17, 2001

	TO THE  OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO EACH DOMESTIC BANKING ORGANIZATION SUPERVISED BY THE FEDERAL RESERVE SUBJECT:   Interagency Guidance on Leveraged Financing                      On April 9, 2001, the Federal Reserve, along with the other federal banking agencies, issued guidance concerning sound risk management practices for institutions engaged in leveraged financing.  This guidance augments previously issued supervisory statements on sound credit risk management.1  A copy of the interagency statement is attached.                      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 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.  This 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 attached 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.                      Reserve Banks are asked to forward this SR letter to all banking organizations supervised by the Federal Reserve.  If you have any questions, please contact Michael Martinson, Associate Director, at 202/452-3640 or David Wright, Assistant Director, at 202/728-5854. Richard Spillenkothen Director Attachment (638 KB PDF) Cross Reference:  SR letters 99-23 and 98-18 Notes: 1.   Refer to SR letters 99-23 and 98-18.  Return to text
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