Loan participations can be beneficial for both institutions. The lead (experienced) credit union is able to reduce its risk by participating out a portion, which also allows them the ability to continue to fund new loans if it is too close to the current lending cap.  For the participating credit union, it can create a mentoring relationship, allowing them to gain valuable experience in underwriting and servicing business loans while also limiting its risk exposure.    

Credit unions considering loan participations should be aware of a few important items.  First and foremost is risk appetite.  Risk appetite and management are an integral part of any credit union's plan, but risk management becomes even more important when entering into member business lending or a loan participation agreement.  Business loans are typically much larger in dollar value than consumer loans and inherently are more risky due to the different underwriting standards.    

And while it is imperative the credit union's board determine its risk appetite in advance, that may be a challenge as the board may not have the experience in business lending to fully understand all the associated risks.  Consider having thorough training for the board and management prior to engaging in business lending or loan participations so that an appropriate risk appetite and guidelines can be established.

In addition, several key areas of risk should be considered before entering into business lending and loan participation agreements.   

Concentration risk. The types of loans that the credit union is willing to enter into including dollar exposure.  Don't forget the lessons learned from banks that were too concentrated in real estate.  Inadequate diversification of the loan portfolio in terms of different industries, loan products, terms of loan products or the number of borrowers may result in significant losses.  

Collateral risk. As with any loan ensuring the security interest is perfected and that adequate loan to value ratios are maintained are instrumental in protecting the credit union from potential losses.

Interest rate risk.  Maturity and re-pricing characteristics of loans can have a significant impact on the credit union's interest rate risk profile.  The terms of the participations as well as the interest rates that credit union is willing to accept are vital to controlling interest rate risk.

Management and operational risk.  As stated earlier, it's key to enter into participation agreements with credit unions who are experienced in business lending.  Failure of the institution to properly evaluate and monitor business loans could expose both institutions to significant financial and reputational losses if the loan becomes troubled or uncollectible. 

Legal/compliance risk.  Have an attorney with experience in credit unions and loan participations review the agreement before execution.  A well-drafted participation agreement that spells out each institution's rights and obligations can help both institutions avoid–and resolve–any conflicts that may arise down the road

By providing available credit to businesses in need, credit unions can be a vital resource to small businesses.  Loan participations can be a great way for credit unions to be a major contributor in helping our ailing economy while mitigating their risk exposure. 

Harvey L. Johnson, CPA, is a senior manager at Witt Mares, PLC.
Contact 757-627-4644 or  hjohnson@ wittmares.com