Participation loans are

loans In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...

made by multiple lenders to a single borrower. Several banks, for example, might chip in to fund one extremely large loan, with one of the banks taking the role of the "lead bank". This lending institution then recruits other banks to participate and share the risks and profits. The lead bank typically originates the loan, takes responsibility for the

loan servicing Loan servicing is the process by which a company (mortgage bank, servicing firm, etc.) collects interest, principal, and escrow payments from a borrower. In the United States, the vast majority of mortgages are backed by the government or governme ...

of the participation loan, organizes and manages the participation, and deals directly with the borrower.

Credit unions A credit union, a type of financial institution similar to a commercial bank, is a member-owned nonprofit financial cooperative. Credit unions generally provide services to members similar to retail banks, including deposit accounts, provision ...

can also participate loans in the same manner. "Participations" in the loan are sold by the lead

financial institution Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...

("FI") to other FI's. A separate

contract A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tran ...

called a loan participation agreement is structured and agreed among the FI's. Loan participations can either be made on a

pari passu ''Pari passu'' is a Latin phrase that literally means "with an equal step" or "on equal footing". It is sometimes translated as "ranking equally", "hand-in-hand", "with equal force", or "moving together", and by extension, "fairly", "without pa ...

basis with equal risk sharing for all loan participants, or on a senior/subordinated basis, where the senior lender is paid first and the subordinate loan participation paid only if there are sufficient funds left over to make the payments. Such senior/subordinated loan participations can be structured either on a LIFO (Last In First Out) or FIFO (First In First Out) basis (see

FIFO and LIFO accounting FIFO and LIFO accounting are methods used in managing inventory and financial matters involving the amount of money a company has to have tied up within inventory of produced goods, raw materials, parts, components, or feedstocks. They are used t ...

). The most compelling reasons that financial institutions use participation loans are as follows: *Selling loan participations allows the lead bank to originate an exceptionally large loan that would otherwise be too large for it to handle by itself. By engaging other banks as participants, the lead bank can remain within its own legal lending limits and still come up with sufficient cash for funding. *Banks that buy loan participations share in the profits of the lead bank. If a lending institution isn't doing much business on its own, or is in a slow market, it can team up with a profitable "lead bank" in a healthier market to generate more lending income. *Buying participation loans is a way for banks to diversify their

assets In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...

. By investing a variety of loans in different locales, they reduce their

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

and exposure to potential losses if a calamity, such as a natural disaster or severe

economic depression An economic depression is a period of carried long-term economical downturn that is result of lowered economic activity in one major or more national economies. Economic depression maybe related to one specific country were there is some economic ...

, were to strike their particular community. *Selling loan participations allows a bank to reduce its

credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

to a customer or specific community that entails greater than average risk. *Selling participation loans allows the lead bank to keep control of more of an important customer relationship or even an entire customer relationship of large customers of the bank, instead of sharing the relationship with other competing banks.

References

{{Reflist Credit Loans