By David Etter, Director, Wipfli
Participation loans for credit unions can open the door to new commercial lending revenue. But without the proper due diligence, that opportunity can expose your credit union to a new layer of risk.
Participant credit unions, at times, take on exposures they don’t fully understand, and regulators are paying closer attention. Keep reading for some actions CEOs and CLOs should prioritize before agreeing to a participation loan, and once the loan has been issued.
What Is a Participation Loan?
Every credit union operates under a legal lending limit, a cap on how much it can lend to any single borrower, typically defined as a percentage of capital. Many credit unions also set an internal limit below that legal ceiling to manage concentration risk.
When a borrower needs more than the lead credit union can lend on its own, or more than it is comfortable lending due to other risks such as collateral concentrations, the lead can bring in another credit union or financial institution (the participant) to share the loan. The lead originates and services the loan. The participant purchases a percentage of it, typically on a pari passu basis, meaning ownership is proportional. If you own 50% of the participation, 50% of the payments come to you. And if there’s a loss, you will absorb 50% of that as well.
These arrangements are common and allow credit unions to deploy capital in commercial lending without having to originate every borrower relationship from scratch. But the revenue potential does come with risk.
Participation lending is only an option for commercial loans. It’s not allowed for consumer lending or residential mortgages. These are business loans to commercial borrowers, and they carry the credit complexity associated with that line of business.
Why Participation Loan Risk Is Often Underestimated
The challenge with loan participation risk for credit unions isn’t that the concept is complicated. It’s that the structure can create a false sense of security.
Because the lead handles the borrower relationship, services the loan, and manages day-to-day communication, it’s easy for the participant to slip into a passive role. They often rely on the lead to flag problems, provide updates, and make the right calls. That’s a risky assumption, and it’s one regulators won’t accept as an excuse.
Three Ways Participant Credit Unions Can Protect Themselves
If your credit union agrees to be a participant in a loan, here are three actions it should take to mitigate the risks of losing money and regulatory violations:
1. Do your own independent credit evaluation
The lead credit union will provide an underwriting package when it brings you a participation opportunity, including financial statements, borrower background, collateral analysis, and risk conclusions. That package is a starting point, not a substitute for your own work.
As a participant, you need to conduct an independent credit evaluation of the borrower. Apply the same credit standards you’d use for a borrower that walked through your door to originate a new loan. That means running the credit through your own policies, stress-testing cash flow under your own assumptions, and reaching your own risk conclusion.
Too often, participant credit unions accept the lead’s underwriting, note somewhere in the file that they “reviewed” it, and sign off. That’s not an independent evaluation. Many credit unions have gotten away with it, but regulators are starting to crack down and ask harder questions.
If you can’t answer these questions with documented evidence, you don’t have a defensible position:
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What did your credit analyst independently conclude?
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How did you apply your own underwriting criteria?
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Where’s your work?
The fix isn’t complicated. Apply your credit policy to the participation loan the same way you’d apply it to any commercial loan originated in-house. If the loan wouldn’t meet your standards for direct origination, you should pass on the participation loan.
2. Get the participation agreement right
The participation agreement is a legal contract that governs the responsibilities of the lead and the participant in the loan. Don’t treat it as a mere formality. Review the agreement carefully before signing. Negotiate the terms that protect your interests. And don’t assume the lead’s standard form covers everything you need.
A well-structured participation agreement for commercial loans should clearly define:
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The lead’s obligations for collecting and delivering updated borrower information to the participant
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Specific timelines for when that information is due and in what format
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How loan payments are received and remitted, including any netting arrangements
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How interest income will be distributed based on each party’s ownership percentage
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What happens when there’s a problem, how troubled credit is managed, and who leads the workout
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What actions the lead can take unilaterally vs. those that require participant consent
This last point is significant. If the lead decides to modify loan terms, extend the maturity or advance additional funds, do they need your approval? If the agreement doesn’t spell it out, you may have no say at all.
Credit unions that sign vague participation agreements may find themselves without current borrower financials and without any clear path to demand them. If the agreement doesn’t specify when the lead must provide annual updates, it’s very difficult to enforce. And if you can’t enforce information flow, you can’t monitor the credit.
3. Update your own books every year
Buying into a participation loan doesn’t mean you can set it aside and wait for the lead to tell you if something changes. Participation loans on your books are your assets. You’re responsible for monitoring them like any other loan in your commercial portfolio.
That means completing a formal internal evaluation that includes reviewing current borrower information, updating the risk rating, and assessing whether the borrower remains capable of servicing the debt. This needs to be done at least annually. You can’t rely on the lead’s risk rating. You also can’t assume that because the lead hasn’t raised a concern, there isn’t one. You must do your own analysis.
The data you need will flow through the lead, which is one more reason the participation agreement is important. But even when the lead is slow to provide information, it’s the participant’s responsibility to follow up and close the gap. Not having the information is a monitoring failure.
When conducting your annual review, the key information to gather and document includes:
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Current financial statements or business tax returns for operating companies
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Rent rolls, lease schedules, and operating statements for non-owner-occupied commercial real estate
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Evidence of consistent cash flow sufficient to service debt over at least the next 12 months
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Any material changes to the borrower’s business, ownership, or collateral position
Regulators define “adequate monitoring” to include at least annual analysis of the borrower’s ability to repay. Be sure that the documentation is filed.
The Regulatory Lens You Should Be Looking Through
When regulators examine how a credit union handles its purchase participations, they’re measuring your practices against the interagency guidance on credit risk review. That guidance sets the expectation that participant institutions maintain independent credit analysis, timely information flow, and current risk ratings, regardless of whether the credit is originated in-house or purchased.
Credit unions that can demonstrate a documented independent evaluation at origination, a participation agreement that drives timely information exchange, and annual monitoring with current risk ratings are in a strong position. Those who can’t are creating unnecessary exam risk and potentially credit risk.
Wipfli's loan review professionals work with participant institutions to evaluate purchased participations as part of a comprehensive credit risk review. They can help assess whether independent evaluations were completed at origination, whether monitoring is current, and whether annual risk rating updates align with the institution’s own credit policies.
Connect with Wipfli to learn more.
