Participation Loan

A participation loan is a loan originated by one lender, the lead, which then sells undivided shares in it to other lenders, called participants. The participants put up part of the money and receive their share of interest and principal, but they have no contract with the borrower: the borrower deals only with the lead, often without knowing that others are involved. The structure is widely used by community banks and credit unions to make loans larger than they could hold alone.

Participations are a cousin of loan syndication, but the legal shape is different. In a syndicate every lender signs the loan agreement and has its own claim on the borrower; in a participation only the lead does, and the participants hold a contractual claim against the lead. In the international loan market the same idea is called a sub-participation. The term "participation mortgage" can also mean something else entirely: a property loan in which the lender shares in rental income or price gains.

Imagine a shopkeeper who agrees to supply a large order to a customer but cannot afford to buy all the stock alone. She quietly asks two other shopkeepers to chip in, promising each a share of the payment when the customer pays. The customer only ever deals with her and never meets the other two.

A participation loan is the lending version. One bank makes the loan and keeps the relationship. Other banks give it money in exchange for a slice of the repayments. They take on part of the risk that the borrower does not pay, but they also rely on the first bank to collect the money honestly and pass it on.

1. Origination. The lead underwrites, documents and funds the loan, and keeps the collateral in its own name.
2. Sale of participations. The lead signs a participation agreement with each participant, selling an undivided percentage of the loan, often at the start but sometimes later.
3. Servicing. The lead collects payments, monitors the borrower and passes each participant its pro rata share, usually keeping a servicing fee.
4. Decisions. The agreement sets which decisions the lead can make alone and which, such as releasing collateral or cutting the rate, need participants' consent.

Participants are expected to carry out their own due diligence and underwriting rather than relying only on the lead's credit memo.

• Lending limits. US national banks are limited in how much they may lend to one borrower in relation to their capital, and states impose similar rules. Selling participations lets a small bank keep a large client within its exposure limit.
• Diversification. Buying participations lets lenders with surplus funds reach borrowers, regions or sectors they could not originate themselves, which reduces concentration risk.
• Liquidity and balance sheet. A lead can free up funding or capital, while a participant with deposits but little local loan demand can put them to work.
• Relationship. The borrower keeps one bank and one set of documents, which suits smaller commercial, agricultural and real estate loans.

Among credit unions, participations are common enough that the US National Credit Union Administration has a specific rule for them, 12 CFR 701.22, which sets conditions on written agreements, underwriting and limits.

The participant takes two layers of risk. The first is ordinary credit risk on the borrower. The second is counterparty risk on the lead: if the lead fails, the participant must show that its share was a true sale and not simply a loan to the lead, or it may be treated as an unsecured creditor of the failed bank. US bank failures, from the 1980s through the period after the 2008 financial crisis, produced disputes about this point and about leads who acted against participants' interests when loans went bad.

Participants also have limited control. They cannot enforce against the borrower directly, may have little say over a loan covenant waiver or restructuring, and depend on the lead's servicing quality. Supervisors therefore expect buyers to treat participations as their own loans, monitor them independently and include them when measuring exposure.

Whether the lead can remove the sold share from its balance sheet depends on accounting rules. Under US GAAP (ASC 860) a share must meet the definition of a "participating interest", including pro rata sharing of cash flows and no recourse beyond standard representations. Under IFRS 9 the lead must pass the cash flows through and transfer substantially all risks and rewards. If the test is failed, the transaction is treated as a secured borrowing and the full loan stays on the lead's books for regulatory capital purposes. Participations that are packaged into tradable securities move into the separate world of securitization.

• National Credit Union Administration
• Federal Deposit Insurance Corporation