Because of their size and limited capital, many local community banks can’t meet customer loan requirements, so they often join forces with other banks to make larger loans.
Though widespread, the practice, called “participation lending,” has its disadvantages, and can get a bank in trouble.
In the 1980s, for example, several banks that did participation loans with Oklahoma’s Penn Square Bank were burned when borrowers defaulted. The banks involved were so seriously damaged that the government forced their sale.
“There is a danger if you’re not an equal partner on a loan and there’s some difficulty (with a borrower),” said Jim Kelley, chief executive officer of Discovery Bancorp in San Marcos. “The lead bank is going to be driving the boat.”
Discovery does a minimal amount of participation lending. It holds about $6 million in such loans, or 4 percent of its portfolio, Kelley said.
Plenty Of Participation
But some local banks are involved in participation lending on a much larger scale.
Seacoast Commerce Bank in Chula Vista held $11.6 million in participation loans as of June 30. As a percentage of its loan portfolio of $48 million, that’s 24 percent, a ratio some bankers say is too high.
While there is no legal maximum ratio banks can hold in participation loans, bankers say regulators would regard high ratio of participation loans unfavorably.
“It’s probably prudent not to go over 20 percent,” said Rick Mandelbaum, CEO of Landmark National Bank in Solana Beach. “You don’t want to tie up all your money in participations because you want to have enough funds available (to) serve your own customers.”
Landmark National held $19 million, or 20.5 percent, of its portfolio in participation loans as July 31, Mandelbaum said. The bank’s maximum loan limit amount is $1.65 million.
Requests for comment on the maximum ratio of participation loans were not returned by several state and federal agencies that monitor banks.
Recent Abuses
The Office of the Comptroller of the Currency, the federal agency that regulates national banks, recently released a memo on the subject that outlines policies governing the practice.
The OCC said while the purchase and sale of participation loans are established banking practices, “recent abuses have highlighted the need for the Office to remind banks of prudent banking practices for these transactions.”
Doug Shearer, CEO of Seacoast Commerce Bank, defended his bank’s 24 percent ratio of participation loans, saying the key determinant isn’t the number of participation loans but the credit quality, and his credit quality for the portfolio is immaculate.
“It all gets down to the bank you’re participating with and their credit quality,” he said.
State regulators visited Seacoast in March and gave the institution “a clean bill of health,” Shearer said.
In addition, as of June 30, the bank reported zero loan delinquencies and past due loans on its books, he said.
Common Practice
Larry Hartwig, CEO of California Community Bank in Escondido, said asking another bank to participate in a loan because of lending limits is commonplace among community banks. He added that there is nothing inherently dangerous with the practice.
California Community holds 15 percent of its $78 million portfolio, or $12 million, in participation loans. The bank partners mostly with a group of other San Diego community banks that include San Diego Trust, 1st Pacific Bank of California, Security Business Bank and Landmark National.
Banks that do “participations” often can’t fund all of a loan because of limitations on the maximum loan limits that are contingent on a bank’s capital.
For example, California Community Bank is limited to $5.5 million on a secured loan because of its capital base of $22 million.
If a customer needs a $7 million loan, the bank can find the remaining $1.5 million through participating or selling that part of the loan to another bank. The secondary lender must do all the research on the borrower as if it were the lead bank.
Back-Seat Driver
Hartwig said the peril of a minority position is not being in control if the loan goes sour. “If you’re only making 25 percent of the loan, you’re not in the driver’s seat and you have a partner to contend with,” he said.
But, in most cases, banks cooperate, even when loans go bad, as required by regulators, Hartwig said.
He said an unwritten rule among banks is not to exceed 20 percent of the loan portfolio with participation loans. If it does occur, banks “better be prepared to explain to regulators why, particularly if many of the loans are out of the bank’s market.”
San Diego National Bank, with more than $2 billion in assets, is among the largest banks in the region. Yet, only 10 percent of its portfolio consists of participation loans, according to Sam Jeppson, the bank’s chief credit officer.
“We’re only involved with internal participations,” Jeppson said, referring to six other affiliate banks owned by SDNB’s parent company, FBOP Corp., based in Oak Park, Ill. The seven banks boast $13.6 billion in assets. Because of SDNB’s capital of $246 million, it can make loans up to $37 million.
However, if it needs larger loan funding, it would find a partner bank within the FBOP family to do the deal.
In most cases, participation loans demonstrate how banks can work with each other, providing supplementary funding when a bank is unable to make the full loan by itself, bankers said.
“There’s a sort of gentlemen’s agreement about this,” Mandelbaum said. “If I can’t do one, then you’ll help me (by providing the rest of the loan), and later on, you’ll send me one.”
