A syndicated loan (or "syndicated bank facility") is a large loan in which a group of banks provide funds for a borrower, usually severally but without joint liability. There is usually a lead bank or group of banks (the "Arranger/s" or "Agent/s") that takes a percentage of the loan and syndicates or sells the rest to other banks. A bilateral loan, only involves one borrower and one lender (often a bank or financial institution.) A syndicated loan is a much larger and more complicated version of a participation loan. There are typically more than two banks involved in a syndication.
Syndicated loans can be underwritten or arranged on a best endeavours basis. Where a loan is underwritten the Arrangers or Agents guarantee the terms and conditions and costs of the loan BEFORE it is sold to other banks, essentially removing the market risk for the Borrower.
Reasons for syndicated lending
A primary reason for loan syndication is risk mitigation. Like insurance, a loan is an assumption of risk. For a certain class of loan, with certain rules, the bank might believe that it is likely that 5% of all borrowers may go bankrupt. If the bank's cost of funds is a hypothetical 5%, the bank needs to charge more than 10% interest on the loan to make a profit. In general, banks and the financial markets use risk-based pricing, charging an interest rate depending on the risk of the loan product in general or the risk of the specific borrower. The problem with larger businesses loans, however, is that there are fewer of them. So, if the bank has the only large business loan and if that business happens to be one of the 5% that defaults, then the bank loses all its money. For this reason, it is in the best interest of all banks to split, or "syndicate" their large loans with each other, so each get a representative sample in their loan portfolios.
Banks also often face prudential or internal concentration limits with regard certain borrowers which may require loans be syndicated regardless of the credit or default risk applicable to that counterparty.
A second, often criticized reason for syndicating loans is that it avoids large or surprising losses and instead usually provides small and more predictable losses. Smaller and more predictable losses are favored by many management teams because of the general perception that companies with "smoother" or more steady earnings are awarded a higher stock price relative to their earnings (benefiting management who is often paid primarily by stock). Critics, such as Warren Buffett, however, say that many times this practice is irrational. If the bank could still get a representative sample by not syndicating, and if syndication would reduce their profit margins, then over the long term a bank should make more money by not syndicating. This same dynamic plays out in the investment banking and insurance fields, where syndication also takes place.
From the Borrowers point of view, a syndicate of banks provides access to a larger pool of funding than may be available from a single bank or lender and creates relationships that can be used to procure other finance products, often with competitve tension
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