Loan Strip: What It Means and how It Works

What is a Loan Strip?

A loan strip is a commercial loan arrangement through which the initial lender on a long-term loan, such as a bank, can obtain funding for that loan from other lenders or investors.

A loan strip represents a share of the long-term loan (such as a five-year loan). When the loan strip reaches maturity, its holder will receive an agreed-upon amount of money. The maturity of a loan strip is usually short term (often 30 or 60 days). A loan strip is also known as a strip participation or, more formally, a short-term loan participation arrangement.

How a Loan Strip Works

When a bank or other lender makes a long-term loan, it can sell loan strips to investors in order to raise capital to fund the loan. For example, when a bank sells a 60-day loan strip, it is getting money to cover that portion of the loan.

But at the end of the 60 days, the source of funding for the loan has dried up. The bank must either resell the loan strip to that same investor, find a new investor, or fund the loan strip itself.

Regulations on Loan Strips

Under certain circumstances, loan strips may be classified as borrowed amounts in the bank's quarterly financial report to regulators, known as a call report. Since March 31, 1988, bank regulators have considered a loan strip to be a borrowed amount if the investor has the option not to renew the loan strip at the end of the term and the bank is obligated to renew it.

In that case, loan strips are treated not as sales, but as borrowings. The loan strips are then considered deposits and become subject to reserve requirements for depository institutions as set forth by the Federal Reserve under Regulation D.

Furthermore, if the original investor does opt not to renew the loan strip at the end of the maturity period, the depository institution that sold the loan strip must take on the responsibility of funding the loan strip itself. That's because the borrower's loan terms typically extend far beyond the loan strip's maturity period.

For example, the borrower of the loan being sold as loan strips may have signed on for a loan period of one year, five years or longer—or may have arranged for a revolving line of credit of similar duration. In effect, loan strips bear the characteristics of a repurchase agreement because the bank that is selling the loan strip agrees to buy it back from the purchaser at the purchaser’s discretion.

Loan strip transactions can involve deposit liabilities, such as acknowledgments of advance, promissory notes or other obligations. As such, exemptions from the definition of a deposit as outlined in Regulation D may be applied to these liabilities. For example, when a domestic bank sells a loan strip to another domestic bank, that loan strip may be exempt from deposit requirements as set forth in Regulation D.