Financial Innovation: Recent Changes to Loan Participations
At its September 2023 meeting, the NCUA board unanimously approved a final rule that would amend NCUA’s existing regulations to make it easier for credit unions to work with third-parties in the lending space, such as financial technology (FinTech) companies. The rule took effect on October 30, 2023. NAFCU’s Regulatory Affairs team has published a members-only final regulation summary of this final rule. Let’s review some of the compliance implications of these recent changes:
This week’s blog will focus on the effect these changes will have on “loan participation,” which are covered by section 701.22 of the NCUA regulations. Generally speaking, a loan participation occurs whenever the ownership interests in a loan is divided up and sold. Under section 701.22, federally insured credit unions (FICUs) can buy participation interests in loans under certain conditions. The regulation requires that there be a written loan participation agreement, which must meet certain requirements. Additionally, the rule requires that the originating lender must retain an interest in the loan – at least 5 or 10 percent, depending on institution type – for the life of the loan. While section 701.22 focuses on purchasing participation interests, FICUs are also permitted to sell interests in loans they’ve made (but an FICUs which purchase those interests would be subject to the purchasing requirements of section 701.22).
The recent financial innovation rule made one particularly notable change with regards to loan participations. FICUs often engage in “indirect lending” relationships, in which they work with a third-party to facilitate transactions with new borrowers – for example, many credit unions may work with an auto dealership, who will partner with the credit union for financing of loans on vehicles the dealership sells. The recent changes to the lending rules have implications for these relationships. Section 701.22 now defines the term “originating lender” to include “a participant that acquires a loan through an indirect lending arrangement as defined under § 701.21(c)(9).”
Importantly, this section refers to section 701.21(c)(9) which defines “indirect lending arrangement” to mean:
“a written agreement to purchase loans from the loan originator where the purchaser makes the final underwriting decision regarding making the loan, and the loan is assigned to the purchaser very soon after the inception of the obligation to extend credit.”
Putting these things together, the rules state that if a credit union makes the final underwriting decision and is assigned the loan soon after the inception of the obligation, then the credit union will be treated as the “originating lender” of the loan for purposes of section 701.22. This means that, if interests in the loan were to be divided up and sold as participation interests, the “originating lender” who must retain an interest in the loan would not be the indirect lending partner (i.e. the auto dealership) which interacted with the borrower, but instead would be the credit union that partnered with them and made the final underwriting decision. The preamble notes that modern technology now allows for almost instantaneous assignment of loans, meaning that credit unions may be making the underwriting decisions and immediately receiving assignment of the loans as soon as they’re made, which points in favor of treating the credit union as the originating lender.
One implication is that credit unions may now find it easier to work with third parties to find potential member-borrowers and then sell interests in those loans without needing to keep the third-party involved after the initial stages. During its discussion of this rule at its September 2023 meeting, the NCUA board noted that these changes could allow FICUs to expand beyond relationships with auto dealers to form lending arrangements with other third-parties, such as FinTech companies. However, the board also stressed that due diligence when entering third-party relationships will remain important.
Other Notable Changes
The financial innovation rule is dense, and we cannot cover the entire thing in a single blog – as mentioned above, NAFCU members can check out the final regulation summary our Regulatory Affairs team has written for this rule. However, there were at least two other notable things in the final rule that we wanted to highlight regarding loan participations:
Clarification Regarding Which Rule Applies
The final rule notes that there was some confusion amongst credit unions regarding whether a transaction was a loan participation or an eligible obligation. Eligible obligations are covered by section 701.23 of the NCUA regulations and occur when a Federal Credit Union (FCU) buys or sells, in cover situations in which an FCU buys part of a loan, but less than the entire thing, which is typically how loan participations are described as well. Thus, there were some situations that seemed like they could fit within the definitions of either activity, creating confusion amongst credit unions regarding which provision applied.
The new amendments to these rules add a provision to section 701.23 that clarifies that the eligible obligation rules only apply if the transaction does not meet the definition of “loan participation.” Thus, when a transaction could fit under either definition, the rule now defaults to the transaction being treated as a loan participation. Section 701.23 only applies if the transaction involves a borrower that is a member of the FCU and the transaction does not fit the definition of a loan participation, such as when the originating lender does not retain an interest in the loan. According to the preamble, the has been a long-held position of NCUA, which is just now being codified into the regulations.
Which Types of Interests Qualify
In the preamble to the final rule, NCUA notes that merely selling the interest on a loan (and not the principal) would not be sufficient. The agency states: “[t]o meet the definition of a participation interest under [Generally Accepted Accounting Principles or GAAP], the transferor generally must sell a pro-rata share of principal and interest…” (emphasis added). The agency then states that the sale of an interest that does not fit the definition of “participation interest” under GAAP would not fit the definition of either loan participation or eligible obligation.
Stay tuned to the NAFCU Compliance Blog, where we’ll continue to update our members on evolving compliance challenges and considerations.
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About the Author
Nick St. John, was named Director of Regulatory Compliance in August 2022. In this role, Nick helps credit unions with a variety of compliance issues.