This post covers all you need to know about loan syndication definition, the reason behind it, benefits and problems associated with it, and lastly types of loan syndication we have in the financial world today.
If you’re into financial analysis and credit management, you will definitely come across the loan syndication.
The first question is, what is it all about?
Definition: loan syndication can be defined as a process whereby institutions share risks and handle a large number of loans.
You can also say that it is an agreement between two or more lending institutions to provide a borrower with credit facility utilizing common loan documentation.
The definition of loan syndication above mean that where a client’s borrowing requirements are extremely large and exceed the capacity of one bank, banks will often finance such by grouping themselves into consortium of banks to mmet such financing requirements.
Any two or more banks can provide syndicated loans.
This was exclusive function of merchant banks before the liberalization of the banking industry and the introduction of universal banking.
Presently, loan syndication can be undertaken by any group of banks or a combination of merchant and commercial banks.
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There are various reasons given why banks and other financial intermediaries enter loan syndication agreements.
Banks may enter into the syndication for the following reasons;
1. To confirm with banking Act which prescribes the maximum amount that can be lent to a single borrower.
When the loan being requested is in excess of this maximum, then a syndication would be undertaken to provide the entire amount. For example, section 20 (1) of banks and other financial institutions Act 1991 stipulated that;
A bank shall not, without the prior approval in writing of the central bank grant to: any person, any advance, loan or credit facility or give an financial guarantee or incur any liability on behalf of any person so that the total value in advance.
Loan credit facility, financial guarantee or any liability in respect of the person is at any time more than 20% of the share holders funds unimpaired by losses, and for the purpose of this paragraph, all advances, loan or credit facilities extended to an person shall be aggregated and shall include all advances, loans or credit facilities extended to any subsidiaries or associates of a body corporate.
2. In order to comply with sectorial allocation of credit, banks could lend through loan syndication so as to meet the maximum prescribed limit for each sector of the economy particularly the preferred sectors.
3. When banks are facing liquidity problem, they could embark on loan syndication to provide loans for viable projects, instead of declining such request in their entirety.
4. Since loans are most profitable and risky assets, banks would like to protect themselves by sharing the risk through loan syndication.
It is a bad lending policy for a bank to pull it’s egg in one basket, sharing the risk reduces the level of bad debt a bank carries.
5. Banks likes to identify themselves with the progress of viable projects. Through loan syndication, many banks are associated wit the progress and economic growth of corporate bodies and the government.
6. Control, management and repayment procedures are better streamlined in a syndicatated credit than when the same customer borrows the same amount from different banks on a participatory basis.
7. Sometimes there’s no group monitoring or the loan after it has been made because of loan syndication or probably syndicated participants have delegated such monitoring functions to lead the bank.
The consequences of this is that the failure of the lead bank to monitor the loan project effectively will mean the failure of all the participating institutions in realising their lending objectives.
8. If a borrower of syndicated loan becomes distressed, the entire lending participants will be affected and this may affect the relationship of the participating institutions in terms of repayment of the loan out of available resources.
In loan syndication, common documentation is used by all the lenders and the lead bank is responsible in ensuring that the conditions precedent and convenient throughout the life of the loan are strictly adhere to.
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There are basically five types of loan syndication. These are;
- The participating method
- The straight syndication method
- The club syndication method
- The domestic syndication method
- The international syndication method
Now let’s look into the types of loan syndication we have on the list.
1. The participating method
In this types of loan syndication, the originating bank structures the loan package and offers singly the total amount to the borrower.
However, the originating bank called the lead bank will subsequently offer participation in the loan package to other banks. This is not a common method of loan syndication.
2. The straight method
This is another types of loan syndication, whereby the originating bank structures the loan package for borrower after which he forms a syndicate of lenders who will provide the amount.
The originating bank called the lead manager does not commit itself by providing the whole amount but arranges for the syndication of lenders.
This is the commonest types of loan syndication in the financial sector.
This is more of a variation of straight syndication method.
In this types of loan syndication, a borrower that considers itself to be of a great credit rating and reputation in the financial circles, structures the loan package and arranges the loan by inviting banks on its own to participate in the provision of the amount required.
4. Domestic syndicated method
This method of loan syndication involves the provision of the amount required in local currency.
The loan package is arranged for a borrower by banks in different countries and the facility may not be in the currency of the borrower.
A good example of the international syndication sector is the syndication arranged in the euro money markets. Loan syndication has assumed international dimension because of the need to provide adequate capital to finance the fast growing economy.
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Problems of syndicated loan
1. The first problem of syndicated loan might come from delay in packaging and putting the credit in place before disbursement to the borrower.
Some of the banks invited by the lead bank to participate in the loan syndication may decline and come up with a reason like loan growth constraints, liquidity problem, over lending on the particular sub-sector of the economy, not believing in the viability of the project, bitter experience with previous lending to same borrower, etc.
Faced with such negative responses, the lead bank will continue to solicit to other banks until the loan amount is fully subscribed.
2. The second problem of loan syndication is that the syndicated loans take up to two years to conclude.
3. After the loan has been disbursed, problem can arise from the unco-operative attitude of the borrower in meeting the terms and conditions in the loan agreement such as submission of progress report, quarterly management accounts, audited accounts, tax clearance certificate.
4. Sometimes, in loan syndication, the borrower may delay in submitting the information or may even not submit them.
5. The payment of interest and principal when due occasionally poses some problems. The borrower may be facing liquidity problems, low sales turnover, diversion of working capital into acquisition of fixed assets or unprofitable ventures.
As such would not be able to meet it’s obligations to the lender when due.
Such problems if not properly handled may lead to rescheduling, restructuring and refinancing of the loan.
Benefits of syndicated loans to the economy
Below are the benefits of loan syndication in a country’s economy.
1. Through syndicated loan, the financial institutions have continued to support the stabilization policy of the government including the economic growth and reduction of unemployment.
2. The industrialisation policy of the government which demands large capital outlay have been sustained by the syndicated loans from the financial institutions.
3. Many large corporate bodies which contribute to the economic growth of the nation have been financed through loan syndication.
4. Through international loan syndication, the country has been able to mobilize the required capital for execution of major economic and social project.
5. Loan syndication provides opportunity for banks to diversify their lending risk.
6. It provides adequate funding needs for large investments which are beneficial to the economy.
7. It widens the financial relationship of the participating institutions.
8. Loan syndication provides greater portfolio diversification for the lenders.
9. Coordinating of syndicated loan is vested on the lead bank thereby reducing the burden on each of the participating banks.
Loan syndication is an offshort of the practice in the middle ages when bankers of that era often distributed financing risk among themselves to support trade flows.
However, the system practiced then was more on a participatory basis because the lenders did not adopt one common loan documentation.
In the modern loan syndication, which is believed to have started in the United States after the second world war. The background to this was the desire of the US government to encourage large scale capital investment to boost the economy.
However, before the second world war, banks in the United States offers only short term loans of not more than one year duration and such loans must be marched with specific deposits.