RESEARCH REPORT ON

RISK MANAGEMENT IN AGRICULTURAL FINANCE

SHAFQAT ULLAH

INSTITUTE OF MANAGEMENT SCIENCES

PESHAWAR PAKISTAN

May 2007
 RESEARCH REPORT ON

RISK MANAGEMENT IN AGRICULTURAL FINANCE

Research report submitted to the Institute of Management Sciences

Peshawar in partial fulfilment of the requirements for the degree of
Master in Business Administration

May 2007
 INSTITUTE OF MANAGEMENT SCIENCES
PESHAWAR

RESEARCH REPORT ON
RISK MANAGEMENT IN AGRICUTURAL FINANCE

Supervisor:

Signature ______________________

Name Mr. Muhammad Rafiq

Designation Coordinator BBA

Coordinator Research & Development Division:

Signature ____________________

Name Mr. Owais Mufti

PREFACE

Research report is the last step in completion of the MBA degree. This is an
excellent and interesting part of the course because a lot is learnt during the
research writing. This helps students in analysing different problems not only for
the course requirement but also for future career.

The present research is about different risks associated with agricultural finance
and its effective management by agricultural credit institution and agricultural
credit department of commercial banks.

The reason for selecting agricultural finance sector for the research is that 50% of
the workforce of the country are involved agriculture and agricultural finance is
one of most important and inseparable part of agricultural business. Risk is a
necessary part of agricultural finance because agriculture is a risky business and
the risk is transferred to agricultural lending institution since they are connected
with agriculture business. Banks surely need an effective risk management policy
to cope with the risks involved in agricultural finance.

Such a research will not only help institutions lending for agricultural purposes
but also people connected with agriculture, livestock etc businesses. And sure
this research report will play its role in this respect.

Shafqat Ullah
MBA (Banking & Finance)
TABLE OF CONTENTS

Topic Pa ge #
P refac e i
Tab l e o f C o n t en t s ii
Li s t o f Gr ap h s iv
Ex ecu t i v e S u m m ar y v

S E CT I O N O NE : INT RO DUCT I O N 1-4

Ch a p ter 1
1 . 1 Bac k gro u n d 1
1.2 Risk 2
1 . 3 R i s k M an ag em e nt 2
1 . 4 Ob j ect i v es o f t he S t u d y 3
1 . 5 S co p e o f t h e W ork 3
1 . 6 S ch em e o f t h e R epo rt 3

S E CT I O N T WO : RE VI E W O F L I T E RAT URE 1 1 -3 0
Ch a p ter 2 : Rev i ew of L i tera tu re 11 -2 3
Ch a p ter 3 : Ri s k an d Ri s k Ma n a geme n t 24-3 0
3.1 Risk 24
3 . 1 . 1 S ys t em at i c R i s k 25
3 . 1 . 2 No n-s ys t em at i c R i s k 25
3 . 2 R i s k M an ag em e nt 25
3 . 3 R i s k M an ag em e nt P ro ces s 26
3 . 3 . 1 R i s k Ident i fi c at i on 27
3 . 3 . 2 R i s k As s es s m en t 27
3 . 4 P o t en t i al R i s k Treat m en t s 28
3 . 4 . 1 R i s k El i m i n ati o n 28
3 . 4 . 2 R i s k M i t i gat i on 29
3 . 4 . 3 R i s k R et en t i on 29
3 . 4 . 4 R i s k Tran s fer 30
 3.5 Li m i t at i on s 30

S E CT I O N T H REE : ANAL YS I S 3 1 -3 4
Ch a p ter 4 : An a l y s i s
4 . 1 C au s e-an d- Eff e ct Anal ys i s 31
4 . 2 C au s es o f Li qu i di t y R i s k 32
4 . 3 C au s es o f Ope r at i o nal R i s k 33
4 . 4 C au s es o f M ark et R i s k 33
4 . 5 C au s es o f W eat her R i s k 34
4 . 6 Th ei r Eff ect 34
4 . 7 Ag ri cu l t u re C re di t Del i ver y 35

S E CT I O N FO UR: RE CO MME NDAT I O NS 3 7 -3 8

CO NCL US I O N 3 9 -4 0
RE FE RE NCE S 4 1 -4 3
LIST OF GRAPHS

Nu mb e r Fi g u re T i tl e Pa g e

Fi gu re 3 . 1 R i s k Treat m en t 28
Fi gu re 4 . 1 Fi s h bo ne Di a gr am 32
Fi gu re 4 . 2 Effect s on P rofi t ab i l i t y 34
Fi gu re 4 . 3 C redi t R eq ui rem ent & Di s bu rs em ent 35
EXECUTIVE SUMMARY

The present research study has been conducted to identify different types of risks
associated with agricultural finance, their possible effects of profitability of
agricultural lending institution and risk management strategies that have been
designed to cope with these risks.

Agriculture businesses have great exposure to risk and this risk not only affects
the farmer but also the institution lending to farmer for agricultural purpose. Risk
has serious consequences for income generation and for loan repayment capacity
of borrower. Agricultural insurance is a useful tool to manage the risks but it has
limited role in agriculture sector of Pakistan especially small farmers have almost
no access. Problems associated with inadequate loan collateral pose specific
problems to agricultural lenders. Lenders consider movable assets, such as
livestock as higher risky forms of security. Market and price risks are due to
market fluctuations in prices particularly where information is lacking and where
markets are imperfect. The relatively longer time period between cultivation and
harvesting means that market prices are unknown at the moment when a loan is
granted. Free trade and exposure to foreign markets increases price risk for
farmers. Countries with smaller markets experience more volatility than markets
with large volume trade. The dispersed farmer-borrowers with small loan volumes
lead to high financial transaction costs both for borrower and institution and
increase perception of high risk. Mismatching the term of loan assets and
liabilities exposes a financial institution to high liquidity risks. The liquidity
position of agricultural lenders is affected by agricultural seasonality. To protect
themselves, banks should carefully match maturity of their loans with that of their
loanable resources.

Risk is defined by the adverse impact on profitability of several distinct sources of

uncertainty. While the types and degree of risk of an organisation or system may
be exposed to depend upon a number of factors such as size, complexity, business
activities, volume etc. Risk management is the process of measuring or assessing
risk and developing strategies to manage it. Strategies may include transferring of
the risk, avoiding the risk, reducing the negative effects of the risk and accepting
some of the consequences of the risk. Traditional risk management covers actions
taken both before and after the risky events occur.

By analysing these risk by fishbone diagram which is developed by Dr. Ishikawa,

it is clear that there are four major categories that affects the banks’ profitability.
Weather risk, liquidity risk, operational risk and market risk collectively have
mostly negative effects on banks’ profitability and therefore often institutions
hesitate in forwarding loan to this sector and eventually the credit demand is not
covered by the supply of credit.

To effectively manage these risks financial institutions need to classify the loan in
terms of risk and should first start lending in low risk zone and then gradually to
high risk zone. The credit risk should be minimised by appropriate collateral and
information database of borrowers’ creditworthiness. The repayment schedule
should be designed as such that is convenient for borrower to repay the loan on
time with interest. Market risk can be minimised by diversifying income
generation sources for rural household. The institution has to design effective risk
management policy and consistently follow it.
CHAPTER: 1

INTRODUCTION

1.1 BACKGROUND:

Agriculture is of vital importance in Pakistan’s economy. It accounts for about

22% to the GDP and about 66% to export earnings. Not only 44.8% of the
workforce are engaged in agriculture but also 65.9% of the country’s population
is living in rural areas, which is directly or indirectly related to agriculture for
their livelihood. Any effect on agricultural performance would affect the large
number of population and of course the growth of the country’s economy as well.

The performance of agriculture has been weak during the fiscal year 2005-06.
Overall agriculture grew 2.5% against the target of 4.2% which is very low as
compared to 6.7% which is the achievement of year 2004-05.

Farmers need seeds, fertilisers, pesticides, agricultural machinery, labour and

farm houses etc and for this they demand funds if they are in short of money for
operation of these activities. This demand is fulfilled by financial institutions,
banks, and co-operatives, NGOs and or by their relatives, friends. But the main
supplier of credit to farmers is financial institutions, co-operatives etc.

In Pakistan there are some specialised agricultural finance institutions such as

ZTBL. Other than these the agricultural credit departments of commercial banks
are also engaged in lending for agricultural purposes. A total of Rs. 111195.168
million was disbursed as loan by all financial institutions for agricultural purposes
during the period of July 05 to Mar07; Rs.91160.959 million was disbursed
during corresponding period last year.

Although there is an increase in agricultural credit disbursement but still the credit
supply is not consistently increasing as the demand is increasing. The reason is
that there many risks involved in agriculture and therefore institutions hesitate to
advance loan for agricultural purposes. The present research is related to same
topic that how different risks involved in agricultural finance affect the
profitability of a bank and how it can be managed effectively.

1.2 RISK:

“The possibility that the outcome of an action or event could bring up adverse
impacts. Such outcomes could either result in a direct loss of earnings / capital or
may result in imposition of constraints on bank’s ability to meet its business
objectives.”1

1.3 RISK MANAGEMENT:

Risk management is a very critical issue in many sectors as well as in agricultural

finance. Agricultural finance needs even more and better risk management
strategies because agriculture is comparatively more risky business.

“Risk management is the process of identifying, measuring or assessing risk and

developing strategies to manage it.”2

1.4 OBJECTIVES OF THE STUDY:

The main objectives of the study are to

1 Find out different risks involved in agricultural finance faced by financial
institutions, co-operative societies, NGOs etc
2 Determine the effects of these risks on the profitability of agricultural
lending institutions.
3 Analyse the risk management strategies that are used to cope with these risks
4 And to suggest recommendations to manage these risk effectively

1
Definition by State Bank of Pakistan
2
Definition by Wikipedia Encyclopaedia
1.5 SCOPE OF THE WORK:

Agricultural finance is faced with many challenges because agriculture is a very

risky business and this risk is then transferred to agricultural lending institutions
because they are connected to it. Since there are many challenges faced by
agricultural finance therefore it is not possible to cover all of them in this research
report.

Therefore this research is limited to the risk management challenge in agricultural

finance. It will cover different risks that financial institutions are facing with in
lending to farmers for agricultural purposes.

Weather risk will be covered in the research that is the main risk in agriculture.
Other than this liquidity risk, credit risk, operational risk etc will be covered in
this research report.

1.6 SCHEME OF THE REPORT:

The first section of the report is the introduction section, in which background of
the topic is discussed. Risk and risk management is defined, objectives and scope
of the research report is described.

In the second section the viewpoints and findings of different researchers on

similar topics have been discussed and comprehensively define risks, its different
types, risk management and risk management process.

In the third section the problems are analysed by using fishbone diagram and
using some data to analyse agricultural finance challenges.
The fifth section of the report is about recommendations. And at the end the
report has conclusion and references.
CHAPTER: 2

REVIEW OF LITERATURE

Agriculture remains a dominant activity in many rural economies of the poorest

nations in the world. A large majority of the poorest households in the world are
directly linked to agriculture in some fashion. Risks in agriculture are most
certainly not independent in nature. When one household suffers bad fortune it is
likely that many are suffering. These common risks are referred to as correlated
risk. When agricultural commodity prices decline everyone faces a lower price.
When there is a natural disaster that destroys either crops or livestock, many
suffer. Insurance markets are sorely lacking in most developing and emerging
economies, and rarely do local insurance markets emerge to address correlated
risk problems. (Skees, Jerry 2003)

Agricultural risk is associated with negative outcomes that stem from imperfectly
predictable biological, climatic, and price variables. These variables include
natural adversities (for example, pests and diseases) and climatic factors not
within the control of agricultural producers. They also include adverse changes in
both input and output prices. To set the stage for the discussion on how to deal
with risk in agriculture, we classify the different sources of risk that affect
agriculture.

Agriculture is often characterised by high variability of production outcomes or,

production risk. Unlike most other entrepreneurs, agricultural producers are not
able to predict with certainty the amount of output that the production process will
yield due to external factors such as weather, pests, and diseases. Agricultural
producers can also be hindered by adverse events during harvesting or collecting
that may result in production losses. (World Bank Report 2005)

Risks impact borrowing farmers and the financial institutions that lend to them.
Active management can reduce these risks. Risks and uncertainty are pervasive in
agricultural production and are perceived to be more serious than in most non-
farm activities. Production losses are also impossible to predict. They can have
serious consequences for income-generation and for the loan repayment capacity
of the borrowing farmer. The type and the severity of risks which farmers face
vary with the type of farming system, the physical and economic conditions, the
prevailing policies, etc. (Klein, B., Meyer, R., Hannig, A., Fiebig, M 1999)

Risks can be of different natures and include those associated with the impact of
unfavourable weather on production, (drought, hail, floods), diseases or pest
damage, economic risks due to uncertain markets and prices, productivity and
management risks related to the adoption of new technologies, and credit risks as
they depend on the utilisation of financial resources and the repayment behaviour
of farmer clients. The relative importance of these different risks will vary by
region and by type of farmer. For example, marketing risks are greater for mono-
crop cultures in developing countries, which depend on volatile world markets.
These risks will also decrease as the level of education of farmers and the
availability of information on markets, prices and loan repayment behaviour
increase. In some cases, especially for relatively high technology farming that
involves significant investments, agricultural insurance may be useful as a risk
management tool. But it should be used only for specific crop/livestock
enterprises and for clearly defined risks (Roberts and Dick, 1991; Roberts, R.A.J
and Hannig, A 1998)

Agriculture is inherently dependent on the vagaries of weather, such as the

variation in rainfall. This leads to production (or yield) risk, and affects the
farmers’ ability to repay debt, to meet land rents and to cover essential living
costs for their families. But the effects of weather events also matter for rural
lending institutions and agri-businesses, as they determine the risk exposure of
borrowers and input providers. With weather conditions affecting a large share of
business activity, many developing countries in Sub-Saharan Africa and other
parts of the world display a high sensitivity of both agricultural and GDP to
fluctuations in rainfall (Benson and Clay, 1998 and Guillaumont, Guillaumont,
Jeanneney and Brun, 1999). Ultimately, the precariousness of farmers and
producers translates into macroeconomic vulnerability.

Developing countries are not just more dependent on weather conditions but also
suffer the brunt of natural disasters (due to the hazardous environmental
conditions), many of which are caused by weather hazards. According to World
Bank (2001), between 1988 and 1997 natural disasters claimed an estimated
50,000 lives a year and caused direct damage valued at more than US$60 billion a
year. Developing countries incurred the vast majority of these costs: 94% of the
world’s 568 major disasters between 1990 and 1998 took place in developing
countries. In Asia, which experiences 70% of the world’s floods, the average
annual cost of floods over the 1990s was estimated at US$15 billion. On the basis
of current trends, these numbers are likely to rise in the future. (Freeman, 1999).

Farmers in developing countries have always been exposed to weather risks, and
for a long time have developed ways of reducing, mitigating and coping with
these risks (Dercon, 2002). Traditional risk management covers actions taken both
before (ex-ante) and after (ex-post) the risky event occurs (Siegel and Alwang,
1999). Examples of ex-ante strategies include the accumulation of buffer stocks as
precautionary savings and the diversification of income-generating activities
through changing labour allocation (working in farm and non-farm small
businesses, and seasonal migration) or varying cropping practices (planting
different crops, like drought-resistant variants, planting in different fields and
staggered over time, intercropping, and relying on low risk inputs). Similarly,
companies may self-insure through high capitalisation and diversification of
business activities. Communities collectively mitigate weather risks with
irrigation projects and conservation tillage that protects soil and moisture.
Examples for ex-post strategies range from farmers seeking off-farm employment,
to distress sales of livestock and other farm assets, to withdrawal of children from
school for farm labour, and to borrowing funds from family, friends and
neighbours (Hanan and Skoufias, 1998).
When a hurricane or an earthquake occurs not everyone has a total loss. Still,
many losses do occur at the same time. Crop losses have similar characteristics.
While events such as too little rain, too much rain, or widespread frost create
widespread crop losses, not every farm experiences the same loss. The challenge
for those insuring losses from hurricanes, earthquakes, and crop disasters is to
have access to enough capital to cover worst-case scenarios. Since catastrophic
risks are not independent, and in the classic sense are uninsurable, special global
markets have emerged to share these risks. The traditional mechanism is to share
catastrophic risk with another insurance entity by what is called reinsurance.
Reinsurance can take many forms. The simplest form to consider is another
insurance policy on the insurance losses for a local insurance provider. Such a
policy can be arranged as a ”stop loss” policy: The local insurance provider pays a
premium to the global re-insurer who agrees to pay for all losses beyond a certain
threshold. As long as the re-insurer mixes this into a global book of business, then
what were correlated risks at the local level become independent risks at the
global level. (Skees, Jerry 2003)

Management of yield or price risk through the purchase of crop insurance

transfers risk from you to others for a price which is stated as an insurance
premium. Crop insurance is an example of a risk management tool that not only
protects against losses but also offers the opportunity for more consistent gains.
When used with a sound marketing program, crop insurance can stabilise
revenues and potentially increase average annual profits.

Crop insurance provides two important benefits. It ensures a reliable level of cash
flow and allows more flexibility in your marketing plans. If you can insure some
part of your expected production, that level of production can be forward-priced
with greater certainty, creating a more predictable level of revenue. With the
elimination of ad hoc disaster payments and deficiency payments, crop producers
will no longer receive government aid during years of crop disasters or price
support payments during low price years. Crop insurance provides partial
replacement for the Federal safety net. (Kaan, Dennis)
Insurance is another formal mechanism used in many countries to share
production risks. However, insurance is not as efficient in managing production
risk as derivative markets are for price risks. Price risk is highly spatially
correlated and, as illustrated by Figure 2.1, futures and options are appropriate
instruments to deal with spatially correlated risks. In contrast, insurance is an
appropriate risk management solution for independent risks. Agricultural
production risks typically lack sufficient spatial correlation to be effectively
hedged using only exchange-traded futures or options instruments. At the same
time, agricultural production risks are generally not perfectly spatially
independent and therefore insurance markets do not work at their best. Skees and
Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et
al. (1982), “good or bad weather may have similar effects on all farmers in
adjoining areas” and, consequently, “the law of large numbers, on which premium
and indemnity calculations are based, breaks down.” In fact, positive spatial
correlation in losses limits the risk reduction that can be obtained by pooling risks
from different geographical areas. This increases the variance in indemnities paid
by insurers. In general, the more the losses are positively correlated, the less
efficient traditional insurance is as a risk-transfer mechanism. For many ideas
presented in this document, a precondition for success is a high degree of positive
correlation of losses.

Agricultural insurance has a limited role in farming, in particular for small

farmers. Its applicability in any given situation is defined by the test as to whether
it is the most cost-effective means of addressing a given risk. When it has a role
the resulting action should be attached to existing insurance operations in order to
take advantage of existing insurance expertise, record keeping and accounting
systems and equipment. On the other hand, agricultural insurance operations
require some special skills. This approach can partly be provided through
manuals, but personal observation through study tours of efficient crop insurance
programs can also be useful.
Mechanism used in many countries to share production risks. However, insurance
is not as efficient in managing production risk as derivative markets are for price
risks. Price risk is highly spatially correlated and futures and options are
appropriate instruments to deal with spatially correlated risks. In contrast,
insurance is an appropriate risk management solution for independent risks.
Agricultural production risks typically lack sufficient spatial correlation to be
effectively hedged using only exchange-traded futures or options instruments. At
the same time, agricultural production risks are generally not perfectly spatially
independent and therefore insurance markets do not work at their best. Skees and
Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et
al. (1982), “good or bad weather may have similar effects on all farmers in
adjoining areas” and, consequently, “the law of large numbers, on which premium
and indemnity calculations are based, breaks down.” In fact, positive spatial
correlation in losses limits the risk reduction that can be obtained by pooling risks
from different geographical areas. This increases the variance in indemnities paid
by insurers. In general, the more the losses are positively correlated, the less
efficient traditional insurance is as a risk-transfer mechanism.

The lack of statistical independence is not the only problem with insurance in
agriculture. Another set of problems is related to asymmetric information — a
situation that exists when the insured has more knowledge about his/her own risk
profile than does the insurer. Asymmetric information causes two problems:
adverse selection and moral hazard. In the case of adverse selection, farmers have
better knowledge than the insurer about the probability distribution of losses.
Thus, the farmers have the privileged situation of being able to discern whether or
not the insurance premium accurately reflects the risk they face. Consequently,
only farmers that bear greater risks will purchase the coverage, generating an
imbalance between indemnities paid and premiums collected. Moral hazard is
another problem that lies within the incentive structure of the relationship
between the insurer and the insured. After entering the contract, the farmer’s
incentives to take proper care of the crop diminish, while the insurer has limited
effective means to monitor the eventual hazardous behaviour of the farmer. This
might also result in greater losses for the insurer.

Since both price and yield risk for agricultural commodities are spatially
correlated, rural finance markets are often limited in their ability to help
individuals either smooth consumption or manage the business risk associated
with producing crops and livestock. For that matter, any form of collective or
group action assisting individuals to manage correlated risk at the local level is
doomed. (Skees, Jerry 2003)

Yield uncertainty due to natural hazards refers to the unpredictable impact of

weather, pests and diseases, and calamities on farm production (Ellis, 1988).
Risks severely impact younger, less well-established, but more ambitious farmers.
Especially affected are those who embark on farming activities that may generate
a high potential income at the price of concentrated risks - e.g. in the case of high
input mono-culture of maize. Subsequent loan defaults may adversely affect the
creditworthiness of farmer borrowers and their ability to secure future loans.
(Klein, B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

A conventional bank practice that protects the lender against possible borrower
default is the requirement of loan collateral such as real estate or chattel mortgage.
Banks use loan collateral in order to screen potential clients (as a substitute for
lack of customer information) and to enforce and foreclose loan contracts in the
event of loan default. The preferred form of conventional bank collateral is
mortgage on real property, which, however, requires clear land titles and
mortgage registration. In general, real estate and land are considered to be “low
risk”, while chattel mortgages of movable assets such as machinery and animals
incur a greater risk, unless these items can be clearly identified, and are properly
insured against theft, fire and loss. In the absence of conventional types of
collateral such as land, livestock and machinery, other forms of supplementary
collateral are sometimes accepted by banks, such as third party guarantees,
warehouse receipts and blocked savings. Without secure loan collateral, it is
expected that there will be a contraction in the supply of bank credit and this will
result in reduced access of small farmer and rural clients to finance.

In the informal credit market, where intimate client knowledge and, often, inter-
linked trade/credit arrangements exist, non-tradable assets or collateral substitutes,
such as reputation and credit worthiness, are much more prominent. Group
lending based on group control and joint and several liability of group members,
and group savings are suitable forms of collateral substitutes. These are
increasingly used by donors and NGOs. It may be effective if groups are
homogenous in their composition, interests and objectives and when problems of
moral hazard can be avoided. However, in many countries, groups of farmers do
not easily meet these criteria. In addition, also due to the long duration of
agricultural loans and high costs of group training, individual lending in
agricultural finance, in general, is much more widespread and might be more
appropriate than group lending. Moreover, successful experience with group
lending is chiefly for non-agricultural purposes. (Binswanger and McIntire, 1987)

Problems associated with inadequate loan collateral pose specific problems to

rural lenders. Land is the most widely accepted asset for use as collateral, because
it is fixed and not easily destroyed. It is also often prized by owners above its
market value and it has a high scarcity value in densely populated areas.
Smallholder farmers with land that has limited value, or those who have only
usufruct rights, are less likely to have access to bank loans. Moveable assets, such
as livestock and equipment, are regarded by lenders as higher risk forms of
security. The owner must provide proof of purchase and have insurance coverage
on these items. This is rarely the case for low-income farm households.

Moreover, there are a number of loan contract enforcement problems, even when
borrowers are able to meet the loan collateral requirements. Restrictions on the
transfer of land received through land reform programmes limits its value as
collateral - even where sound entitlement exists. In many developing countries the
poor and especially women have most difficulties in clearly demonstrating their
legal ownership of assets. Innovative approaches which draw on the practices of
informal lenders and provide incentives to low income borrowers to pay back
their loans have been developed in micro-credit programmes.

Credit risk arises with all over-the-counter contracts as both parties have promised
to pay the other in the future, depending on the final value of an index, and must
be trusted to live up to the promise. This can be contrasted with exchange-traded
securities where the exchange assures final payment. Credit risk or the risk of
default of the counterpart in emerging markets is compounded by currency
transfer risk. In other words it does not matter to the weather risk provider
whether the default is triggered by a macro problem (the Peso crisis, for example)
or counterpart default the risk rating will be equal or lower to the country risk
rating.

Risks are also related to the duration of loans, since the uncertainty of farm
incomes and the probability of losses increases over longer time horizons. Thus,
given the average short maturity of loan-able resources in deposit-taking financial
institutions, and considering the time horizon of agricultural seasonal and
investment loans, commercial bankers are normally reluctant to engage
themselves in agricultural lending. To protect themselves, banks should carefully
match the maturity of their loans with that of their loan-able resources and apply
measures to protect their loan portfolio from potential risk losses.

Input and output price volatility are important sources of market risk in
agriculture. Prices of agricultural commodities are extremely volatile. Output
price variability originates from both endogenous and exogenous market shocks.
Segmented agricultural markets will be influenced mainly by local supply and
demand conditions, while more globally integrated markets will be significantly
affected by international production dynamics. In local markets, price risk is
sometimes mitigated by the “natural hedge” effect in which an increase (decrease)
in annual production tends to decrease (increase) output price (though not
necessarily farmers’ revenues). In integrated markets, a reduction in prices is
generally not correlated with local supply conditions and therefore price shocks
may affect producers in a more significant way. Another kind of market risk
arises in the process of delivering production to the marketplace. The inability to
deliver perishable products to the right market at the right time can impair the
efforts of producers. The lack of infrastructure and well-developed markets make
this a significant source of risk in many developing countries. (World Bank
Report 2005)

Price uncertainty due to market fluctuations is particularly severe where

information is lacking and where markets are imperfect, features that are
prevalent in the agricultural sector in many developing countries (Ellis, 1988).
The relatively long time period between the decision to plant a crop or to start a
livestock enterprise and the realisation of farm output means that market prices
are unknown at the moment when a loan is granted. This problem is even more
acute for perennial tree crops like cocoa and coffee because of the gap of several
years between planting and the first harvest. These economic risks have been
particularly noticeable in those countries where the former single crop buyer was
a parastatal body. These organisations announced a buying price before planting
time. Many disappeared following structural adjustment reforms and privatisation
of agricultural support services. Private buyers rarely fix a blanket-buying price
prior to the harvest, even though various inter-linked transactions for specific
crops have become more common today. These arrangements almost always
involve the setting of a price or a range of prices, prior to crop planting. (Klein,
B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

One way producers have traditionally managed price variability is by entering

into pre-harvest agreements that set a specific price for future delivery. These
arrangements are known as forward contracts and allow producers to lock in a
certain price, thus reducing risk, but also foregoing the possibility of benefiting
from positive price deviations. In specific markets, and for specific products,
these kinds of arrangements have evolved into futures contracts, traded on
regulated exchanges on the basis of specific trading rules and for specific
standardised products. This reduces some of the risks associated with forward
contracting (for example, default). A further evolution in hedging opportunities
for agricultural producers has been the development of price options that
represent a price guarantee that allows producers to benefit from a floor price but
also from the possibility of taking advantage of positive price changes. With price
options, agents pay a premium to purchase a contract that gives them the right
(but not the obligation) to sell futures contracts at a specified price. Price options
for commodities are regularly traded on exchanges but can also be traded in over-
the-counter markets. Futures and options contacts can be effective price risk
management tools. They are also important price discovery devices and market
trend indicators.

For agricultural producers in developing countries, access to futures and options

contracts is probably the exception rather than the rule. However, futures and
options markets in developed countries represent important price discovery
references for international commodity markets and indirect access to these
exchange-traded instruments may be granted through the intermediation of
collective action by producer groups such as farmer cooperatives or national
authorities.8 While futures and options are an important reality for some
commodities, they are not available for all agricultural products. (World Bank
Report 2005)

Freer trade and exposure to world markets increases price risks for farmers,
especially in countries that are price takers in international markets. This will vary
between commodities. For example, relatively small world markets with few
exporting countries (rice) may experience more price volatility than markets
which trade a fairly large portion of the domestic crop production of a larger
number of producing countries (wheat). Moreover only the largest farmers have
access to risk management instruments such as options. (Roberts, R.A.J and
Hannig, A 1998)
When risks are nearly 100 percent correlated, futures exchange markets have
emerged to allow many buyers and sellers of the risk to share risk in an organised
fashion. These markets have allowed participants to protect common or correlated
risks such as changing commodity prices, interest rates, and exchange rates.
Futures markets have a much longer history of successful use than many of the
ideas presented in this paper. Thus, less time will be spent explaining these
markets. Despite well-functioning futures markets, because of the complexity of
and the size needed to participate in futures markets, intermediaries are needed to
facilitate participation in something that looks much more like direct price
insurance. The World Bank has been working with investment banks and with the
International Finance Corporation (IFC) to offer something that is much more
akin to price insurance or an Asian put option. If the domestic price is highly
correlated with a futures market price, it is possible to offer such contracts to local
users in a developing country. The buyer (such as a RFE) would pay a premium
for the right to obtain price protection at some level. For example, if the world
price of coffee is trading at 40 cents, the RFE could purchase an option or
insurance that would pay anytime the world price of coffee drops below 30 cents.
The payment would be made in such a fashion as to make up the difference
between the new lower world price and the 30-cent level. By packing various size
contracts, the investment bankers and IFC hope to make these types of contracts
more accessible to a wide array of users. Kenyan coffee is used in this paper as a
case that may fit the necessary condition that domestic price be highly correlated
with an internationally traded exchange market.

Mismatching the term of loan assets and liabilities exposes a financial institution
to high liquidity risks. Good liquidity management requires priority attention in
agricultural lending. The liquidity position of agricultural lenders is affected, in
particular, by agricultural seasonality. Careful liquidity management is also
needed in the event of large changes in agricultural commodity prices, or natural
disasters. Under these circumstances withdrawals of rural savings and new loan
demand of farmers occur at the same time. Agricultural lenders need reliable
information on the timing of required loan disbursements and scheduled loan
repayments to properly plan and manage their cash requirements. Sufficient funds
should be available at the beginning of the planting season, while the high costs of
keeping loan-able funds idle should be minimised as much as possible.

Ensuring liquidity and adequate cash flow is the same as ensuring the farm's
ability to survive shortfalls in net income relative to various cash obligations.
Assets classified as current on the balance sheet are assets that can be converted
into cash within one operating cycle of the farm business, usually 12 months.
Liquid assets include instruments that yield cash directly or that can be converted
quickly to cash. Liquid assets include cash on hand, supplies, and crops and
livestock to be sold within the year.

Adequate liquidity is essential to ensure a sufficient cash flow. Also, adequate

liquid reserves can facilitate contingency plans for production disasters or poor
market conditions. However, excess liquidity typically generates lower rates of
return than fixed assets.

Timing is critical for ensuring adequate cash flows. With proper planning of
expenses, cash flow needs can be known with reasonable certainty. This allows
you to plan marketing decisions in advance and to take advantage of attractive
pricing opportunities. Improving liquidity to ensure adequate cash flows can
include reducing family living expenditures, using resources efficiently, leasing
assets, and utilising appropriate insurance programs.

Agricultural lending implies high liquidity risks due to the seasonality of farm
household income. Surpluses supply increased savings capacity and reduced
demand for loans after harvest and deficits reduce savings capacity and increase
demand for loans before planting a crop. Also, agricultural lenders face particular
challenges when many or all of their borrowers are affected by external factors at
the same time. This condition is referred to as covariant risk which can seriously
undermine the quality of the agricultural loan portfolio. As a result, the provision
of viable, sustainable financial services and the development of a strong rural
financial system is contingent on the ability of financial institutions to assess,
quantify and appropriately manage various types of risk

Most small farmers and other rural entrepreneurs, due to their dispersed location
and the general poor rural infrastructure, experience great difficulty in accessing
urban-based banks. Rural client dispersion and small loan volumes lead to high
financial transaction costs both for banks and borrowers, and increase the
perception of high risks which banks usually associate with small rural clients. In
addition, current bank practices and procedures may discourage rural clients from
using formal financial services and, in many cases, rural people are even unaware
of the availability of financial services or of the conditions under which these are
available. Moreover, small farmers have to make many visits to banks at office
hours which may not be convenient to them, while banks lack essential
information on the credit history of potential clients, the viability of on-farm
investments, the self-financing capacity of farmers and their repayment capability.

Transaction costs in rural areas are high compared to urban areas, due to problems
of collateral provision, low and irregular income flows and the small amounts
involved in the transactions. Three types of borrower have been identified
transaction costs: non-interest charges by lenders; loan application procedures that
require the applicant to deal with agents outside the banking system, such as
agricultural extension staff, local officials and co-signers; and travel expenses and
time spent promoting and following up the application (Von Pischke, 1991). Due
to these factors the costs of reaching the rural poor and small-scale farmers are
high for financial institutions, which charge high interest rates when compared to
market rates in the formal banking sector. The overall costs of formal borrowing
therefore, in many cases, may result in borrowing from the informal sector
becoming more attractive to small-scale farmers. The challenge still remains to
design and expand the provision of loan products to better service the farming
community and to lower transaction costs to improve the terms and conditions of
lending for agriculture. This will demand improved management of existing rural
financial intermediaries, and innovations or ‘new methods’ in financial
intermediation for the agricultural sector.

Banks may decide to open rural branches, but the demand for bank services needs
to be large enough to warrant setting up such a rural branch network. Efforts to
expand the range of financial services by including savings mobilisation and
current accounts may lead to economies of scale and thus to higher efficiency.
Simplification of loan procedures may minimise the travel time and costs for
individual borrowers, while group lending based on joint and several liability of
group members and liaison with NGOs are other means of reducing costs. In all
cases, the availability of decentralised financial intermediation services is a
precondition for effective on-farm lending. (Roberts, R.A.J and Hannig, A 1998)
Low population density coupled with dispersed location of rural clients make the
provision of formal financial services costly. From the lender’s perspective, the
long distances between communities and the inadequate rural transportation
facilities in many developing countries increase the costs of loan appraisal, loan
monitoring and enforcement of loan repayments (Gurgand, et al. 1996). The use
of mobile loan officers and/or branch offices can be effective in lowering
transaction costs. But mobile facilities may be subject to security risks if bank
staff is required to transport money. The establishment of a rural branch network
reduces the security risks, but branches are costly to maintain and to supervise.

Financial transaction costs of institutional credit can also be high for rural
borrowers. This results from the high opportunity costs of lost working time. A
borrower may have to pay several visits to the bank branch office to conclude
cumbersome loan application procedures which require a long time for
processing. Clients often have to spend much time and money to obtain the
required documents and to find loan guarantors. For very small loans, these costs
can significantly increase the effective lending interest rate (Klein, 1996). While
the decentralisation of field operations has been effective in reducing the
transaction costs in some countries their success depends on the local
environment, infrastructure conditions and the management skills of the financial
institution.

Potentially serious risk problems have raised from the effects of failed directed
credit programmes. The impact on the loan repayment discipline is pervasive.
Borrowers who have witnessed the emergence and demise of lending institutions,
have been discouraged from repaying their loans. Further people have repeatedly
received government funds under the guise of “loans”. Loan clients have been
conditioned to expect concessional terms for institutional credit. Under these
circumstances, the incidence of moral hazard is high. The local “credit culture” is
distorted among farmers and lenders. Borrowers lack the discipline to meet their
loan repayment obligations, because loan repayment commitments were not
enforced in the past. Lenders, on the other hand, lack the systems, experience and
incentives to enforce loan repayment. There is also an urgent need to change bank
staff attitudes and the poor public image of financial institutions in rural areas.

Another effect of a distorted credit culture on the risk exposure of agricultural

lenders is the priority that borrowers give to repaying strictly enforced informal
loans. These are settled before they comply with the obligations associated with
“concessional” institutional credit. This is explained by the fact that losing the
access to informal credit is viewed as more disadvantageous than foregoing future
bank loans (due to the uncertain future of rural financial institutions). Very often
informal lenders have stronger enforcement means than banks.

Farmers always know more about their yield potential and risk than anyone from
the outside (either the government or a private insurer). Such asymmetry in
information creates the dual problems of adverse selection and moral hazard.
Adverse selection occurs when there are problems in classifying risk of potential
purchasers. Because farmers know the most about their potential yields, they will
look at the insurance offer and decide if it is fair or maybe even more than fair.
Those who conclude that it is more than fair will buy. Those who conclude it is
overpriced for their risks will stay out. (Seeks, R. J. 2003)
Policy changes and state interventions can have a damaging impact on both
borrowers and lenders. For the latter they can contribute significantly to covariant
risks. Many low-income economies under structural adjustment programmes
have slashed their farming subsidies. This has had, for instance, a serious effect
on the costs and the demand for fertiliser. Reducing government expenditures as
an essential part of structural adjustment programmes may also affect
employment opportunities in the public sector. Costs may even reduce
agricultural production levels, if extension services are suddenly discontinued.

Policy makers should also carefully consider the structural characteristics of

agriculture for different countries. In general, farms in developing countries are
significantly smaller than farms in countries like the United States and Canada.
For traditional crop insurance products, smaller farms typically imply higher
administrative costs as a percentage of total premiums. A portion of these costs
are related to marketing and servicing (loss adjustment) insurance policies.
Another portion is related to the lack of farm-level data and cost effective
mechanisms for controlling moral hazard.

When making decisions about agricultural risk management programs, policy

makers face a number of constraints. They must consider whether the benefits of
such programs outweigh the costs, and if so, outweigh the net benefits offered by
competing demands on public resources. They must construct the risk
management program so as to minimise distortions in resource allocation and
reduce opportunities for rent-seeking behaviour. They must take into
consideration the status and development of financial and insurance institutions
within the country, any regulatory constraints on the operations of those
institutions, and the infrastructure for enforcing contracts. Finally, it is important
to consider the dichotomy that exists in many countries between smallholder
farms and large farms that produce for export markets.
Policy makers often suggest agricultural insurance programs as an alternative to
free ex post disaster assistance. In principle, insurance programs have many
advantages over ex post disaster assistance. For example, it is often argued that
disaster assistance programs can generate perverse incentives that increase the
magnitude of losses in subsequent disaster events (Barnett 1999; Rossi et al.
1982). But, in practice, agricultural insurance programs have often evolved into
another vehicle for transferring wealth from the public sector to agricultural
producers. Furthermore, there is not much evidence that agricultural insurance
programs have been successful in forestalling free ex post government disaster
assistance. For example, in the United States, more and more costly crop
insurance programs have coexisted with disaster payments for well over 20 years
(Glauber 2004).

Given limited resources in developing countries and the existence of other sectors
that require government attention, these objectives are typically pursued within an
environment of binding fiscal constraints. These objectives target different
segments of people in rural areas and different risk profiles. Growth objectives
focus on increasing profitability so that less poor farmers can continue adopting
production technologies even when high-frequency, low consequence loss events
occur. Poverty reduction policies target the poor and seek to increase their
average income, and decrease the volatility of their income and the likelihood of a
risk event wiping out hard-won asset gains.

Developing countries also have far less access to global crop reinsurance markets
than do developed countries. Reinsurance contracts typically involve high
transaction costs related to due-diligence. Reinsurers must understand every
aspect of the specific insurance products being reinsured (for example,
underwriting, contract design, ratemaking, and adverse selection and moral hazard
controls). Some minimum volume of business, or the prospect for strong future
business, must be present to rationalise incurring these largely fixed transaction
costs. The enabling environment to gain confidence in contract enforcement and
the institutional regulatory environment are critical to create trust that must be
present for a global reinsurer to become involved. These components are largely
missing in developing countries. In fact, a prerequisite for effective and efficient
insurance markets is an enabling environment. Setting rules assuring that
premiums will be collected and that indemnities will be paid is not a trivial
undertaking.

There are various reasons for developing countries to avoid adopting approaches
to risk management similar to the ones adopted in developed countries. Clearly,
developing countries have more limited fiscal resources than developed countries.
Even more importantly, the opportunity cost of those limited fiscal resources may
be significantly greater than those of a developed country. Thus, it is critical for a
developing country to consider carefully how much support is appropriate and
how to leverage limited government dollars to spur insurance markets. In
developed countries, government risk management programs are as much about
income transfers as they are about risk management. Developing countries cannot
afford to facilitate similar income transfers to large segments of the population
who may be engaged in farming. Nonetheless, since a larger percentage of the
population in developing countries is typically involved in agricultural production
or related industries, catastrophic agricultural losses will have a much greater
impact on GDP than in developed countries.
CHAPTER: 3

RISK AND RISK MANAGEMENT

3.1 RISK:

Risk is a concept that denotes a potential negative impact to an asset or some

characteristic of value that may arise from some present process or future event.

Risks are usually defined by the adverse impact on profitability of several distinct
sources of uncertainty. While the types and degree of risks an organisation may be
exposed to depend upon a number of factors such as its size, complexity business
activities, volume etc, it is believed that generally the banks face Credit, Market,
Liquidity, Operational, Compliance / legal / regulatory and reputation risks.

Financial risk is often defined as the unexpected variability or volatility of returns,

and thus includes both potential worse than expected as well as better than
expected returns.

Financial risk in a banking organisation is possibility that the outcome of an

action or event could bring up adverse impacts. Such outcomes could either result
in a direct loss of earnings / capital or may result in imposition of constraints on
bank’s ability to meet its business objectives. Such constraints pose a risk as these
could hinder a bank's ability to conduct its ongoing business or to take benefit of
opportunities to enhance its business.

Regardless of the sophistication of the measures, banks often distinguish between

expected and unexpected losses. Expected losses are those that the bank knows
with reasonable certainty will occur (e.g., the expected default rate of corporate
loan portfolio or credit card portfolio) and are typically reserved for in some
manner. Unexpected losses are those associated with unforeseen events (e.g.
losses experienced by banks in the aftermath of nuclear tests, Losses due to a
sudden down turn in economy or falling interest rates). Banks rely on their capital
as a buffer to absorb such losses.

3.2.1 SYSTEMATIC RISK:

Systemic risk describes the likelihood of the collapse of a financial system, such
as a general stock market crash or a joint breakdown of the banking system. As
such, it is a type of "aggregate risk" as opposed to "idiosyncratic risk", which is
specific to individual stocks or banks.

2.2.2 NON SYSTEMATIC RISK:

Systemic risk should be carefully distinguished from non-systemic risk, which

describes risks which the whole economy faces such as business cycles or wars.
Since systematic risk is caused by factor that affects the whole economy or whole
market therefore it is not possible to be controlled by a person.

3.2 RISK MANAGEMENT:

Risk management is a rapidly developing discipline and is a central part of any

organisation’s strategic management. Risk management evaluates which risks
identified in the risk assessment process require management and selects and
implements the plans or actions that are required to ensure that those risks are
controlled. The focus of good risk management is the identification and treatment
of these risks.

In ideal risk management, a prioritisation process is followed whereby the risks

with the greatest loss and the greatest probability of occurring are handled first,
and risks with lower probability of occurrence and lower loss are handled in
descending order. In practice the process can be very difficult, and balancing
between risks with a high probability of occurrence but lower loss versus a risk
with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of risk - a risk that has a 100%
probability of occurring but is ignored by the organisation due to a lack of
identification ability. For example, when deficient knowledge is applied to a
situation, a knowledge risk materialises. Relationship risk appears when
ineffective collaboration occurs. Process-engagement risk may be an issue when
ineffective operational procedures are applied. These risks directly reduce the
productivity of knowledge workers, decrease cost effectiveness, profitability,
service, quality, reputation, brand value, and earnings quality. Intangible risk
management allows risk management to create immediate value from the
identification and reduction of risks that reduce productivity.

3.3 RISK MANGEMENT PROCESS:

Risk management should be a continuous and developing process which runs

throughout the organisation’s strategy and the implementation of that strategy. It
should address methodically all the risks surrounding the organisation’s activities
past, present and in particular, future.

Risk management is the process of measuring, or assessing, risk and developing

strategies to manage it. Strategies include transferring the risk to another party,
avoiding the risk, reducing the negative effect of the risk, and accepting some or
all of the consequences of a particular risk
3.3.1 RISK IDENTIFICATION:

The first step in risk management is identification of risk. Risk identification can
start with the source of problems or with the problem itself. The source may be
internal or external to the system or organisation.

3.3.2 RISK ASSESSMENT:

Once risks have been identified, they must then be assessed as to their potential
severity of loss and to the probability of occurrence. These quantities can be either
simple to measure, in the case of the value of a lost building, or impossible to
know for sure in the case of the probability of an unlikely event occurring.
Therefore, in the assessment process it is critical to make the best educated
guesses possible in order to properly prioritise the implementation of the risk
management plan. Risk assessment involves identifying sources of potential
harm, assessing the likelihood that harm will occur and the consequences if harm
does occur.

The fundamental difficulty in risk assessment is determining the rate of

occurrence since statistical information is not available on all kinds of past
incidents. Furthermore, evaluating the severity of the consequences (impact) is
often quite difficult for immaterial assets. Asset valuation is another question that
needs to be addressed. Thus, best educated opinions and available statistics are the
primary sources of information. Nevertheless, risk assessment should produce
such information for the management of the organisation that the primary risks
are easy to understand and that the risk management decisions may be prioritised.
3.4 POTENTIAL RISK TREATMENTS:

Once risks have been identified and assessed, all techniques to manage the risk
fall into one or more of these four major categories.
• Retention
• Mitigation
• Elimination
• Transfer
Ideal use of these strategies may not be possible. Some of them may involve
trade-offs that are not acceptable to the organisation or person making the risk
management decisions.

Figure 3.1 Risk Treatment

Severity of Risk Frequency of Risk

Low High

Small Retention Mitigation

Large Transfer Elimination

3.4.1 RISK ELIMINATION:

Includes not performing an activity that could carry risk. An example would be
not buying a property or business in order not to take on the liability that comes
with it. Another would be not flying in order not to take the risk that the
aeroplanes were to be hijacked. Avoidance may seem the answer to all risks, but
avoiding risks also means losing out on the potential gain that accepting
(retaining) the risk may have allowed. Not entering a business to avoid the risk of
loss also avoids the possibility of earning profits.

3.4.2 RISK MITIGATION:

Involves methods that reduce the severity of the loss. Examples include sprinklers
designed to put out a fire to reduce the risk of loss by fire. This method may cause
a greater loss by water damage and therefore may not be suitable. Fire
suppression systems may mitigate that risk, but the cost may be prohibitive as a
strategy.

3.4.3 RISK RETENTION:

Involves accepting the loss when it occurs. True self insurance falls in this
category. Risk retention is a viable strategy for small risks where the cost of
insuring against the risk would be greater over time than the total losses sustained.
All risks that are not avoided or transferred are retained by default. This includes
risks that are so large or catastrophic that they either cannot be insured against or
the premiums would be infeasible. War is an example since most property and
risks are not insured against war, so the loss attributed by war is retained by the
insured. Also any amounts of potential loss (risk) over the amount insured is
retained risk. This may also be acceptable if the chance of a very large loss is
small or if the cost to insure for greater coverage amounts is so great it would
hinder the goals of the organisation too much.
3.4.4 RISK TRANSFER:

Risk transfer means causing another party to accept the risk, typically by contract
or by hedging. Insurance is one type of risk transfer that uses contracts. Other
times it may involve contract language that transfers a risk to another party
without the payment of an insurance premium. Liability among construction or
other contractors is very often transferred this way. On the other hand, taking
offsetting positions in derivatives is typically how firms use hedging to financially
manage risk. Some ways of managing risk fall into multiple categories. Risk
retention pools are technically retaining the risk for the group, but spreading it
over the whole group involves transfer among individual members of the group.
This is different from traditional insurance, in that no premium is exchanged
between members of the group up front, but instead losses are assessed to all
members of the group.

3.5 LIMITATIONS:

If risks are improperly assessed and prioritised, time can be wasted in dealing
with risk of losses that are not likely to occur. Spending too much time assessing
and managing unlikely risks can divert resources that could be used more
profitably. Unlikely events do occur but if the risk is unlikely enough to occur it
may be better to simply retain the risk and deal with the result if the loss does in
fact occur. Prioritising too highly the risk management processes could keep an
organisation from ever completing a project or even getting started. This is
especially true if other work is suspended until the risk management process is
considered complete.
CHAPTER: 4

ANALYSIS

Agricultural finance is faced with many challenges and the most severe challenge
is that of risk management. There are a number of risks associated with
agricultural finance. In the literature review of the report some of the risks have
been highlighted and analysed by different researchers.

In this section the risk associated with agricultural finance are analysed by using
fishbone diagram or cause-and-effect analysis.

4.1 CAUSE-AND-EFFECT ANALYSIS:

Cause-and-effect analysis is a systematic way of looking at the effects and causes

of a problem. In this technique the relationship between dependent and
independent variable is determined through a diagram. The diagram drawn for
this purpose is called “Fishbone Diagram”. The name is because of its shape that
is like skeleton of a fish. Dr. Kaoru Ishikawa, a quality control statistician of the
University of Tokyo developed and it was first used in 1960s. Therefore
sometimes it is also called “Ishikawa Diagram”.

Since Ms. Jennifer Isenhour has used this analysis technique in her research
“ Cause and Effect Analysis of Risk Management to Assess Agricultural Finance”
(2004) therefore the same analysis technique is also used for the present research
to look at the different risks associated with agricultural finance affecting the
overall profitability of agricultural lending institution.
 Figure 4.1

Fishbone Diagram

Liquidity Risk
Market Risk

Lower offer Seasonality of

price for agricultural
crop crops

Entry of big Limited

external players amount of
savings Profitability of
Agricultural lending
Untimely rains
institution
or droughts Dispersed
rural clientele
Lack of
crop High
insurance servicing cost
concept
Weather Risk Operational Risk

The diagram shows different risk categories affecting the profitability of

agricultural lending institutions. Different factors cause a specific risk, which then
affect the profitability of an agricultural lending institution.

4.2 CAUSES OF LIQUIDITY RISK:

Liquidity risk occurs because of agricultural crops’ seasonality. At the cultivation

period farmers borrow from institutions for meeting their funds requirements for
purchase of seeds, fertilisers, pesticides and labour etc and thus the institution
faces with short of funds while in the harvesting season when the farmers repay
their loans, the institutions are in excess liquidity which cause them liquidity risk.
And another reason of liquidity risk is that of lack of saving and deposits with the
bank. This causes the bank the risk of short of funds to lend to farmers for
agricultural purposes.

4.3 CAUSES OF OPERTIONAL RISK:

The people related to agriculture are mostly spread over a vast area in far away
villages. The dispersed agricultural clients cost the bank with higher operational
risk. When a bank want to serve clientele spread over large area or when most of
loan amount is small which is often there in developing country like Pakistan then
it causes the bank with higher servicing costs which result in operational risk.
The bank does not earn that much as it spend on processing, disbursement and
monitoring of agricultural loan.

4.4 CAUSES OF MARKET RISK:

Market risk occurs when the farmer gets a lower offer price for their finished
products in the market than the cost incurred on producing that crop. This causes
a farmer suffer losses as he is not earning that much to repay his loan and
eventually this risk is transferred to the lending institution in form of non-
performing loan. When new external players enter into the market with greater
volume and capital then it results in problems for local farmers. The local farmer
produce at small volume and occupies a small share in the market but when a new
player with huge volume enters into the market then he captures the whole market
and the small farmer cannot survive.

4.5 CAUSES OF WEATHER RISK:

Weather risk is a unique risk involved in agriculture that does not effect other
sectors as much as it affects this sector. Untimely rains, floods, droughts destroy
the crops and result in potential loss to the farmer. Different diseases in animals
can bring potential losses to the farmer-borrower. As in recent time due to bird
flu many poultry farms suffered losses and subsequently the institutions who lend
to them also faced many problems in get their loans paid back. This risk can only
be minimised by taking preventive measures. Crop insurance can be a useful tool
in this regard but is not common in developing country like Pakistan.

4.6 THEIR EFFECT:

All these risks individually and collectively have negative effect on the
profitability of an agricultural financial institution. The weather risk, market risk
minimises the return on loans while the operational and liquidity risk increase the
cost of disbursement loans.

Figure 4.2: Effects on Profitability

Return of
loans
Cost on
loans
4.7 AGRICULTURAL CREDIT DELIVERY

Agricultural Credit Requirement

& Disbursement by Institutions

The table shows the agricultural Year Requirement Disbursement

Rs in million Rs in million
credit requirements and disbursement 1990-91 31952 15207
by institutions. There is a continuos 1991-92 39338 14906
1992-93 45636 16896
increase in the demand for agriculture 1993-94 52694 16243
credit while the supply of credit is not 1994-95 62202 22941
1995-96 68569 19774
increasing at the same rate. 1996-97 78451 19515
1997-98 102570 32984
1998-99 120000 42847
1999-00 136740 39688
2000-01 145860 44043
The same figures are plotted on a Source: Journal of Institute of Bankers Pakistan

graph for graphical representation and we can see the credit requirement curve is
on increase while the credit disbursement curve is not following it.

Figure 4.3
During the whole decade the requirement for agricultural credit are consistently
increasing. The reason is the increasing population of the country needs more
food and dairy products which of course agriculture sector is producing. Farmers
need resources for production. The problem is that this increasing demand for
credit is not accompanied by supply of credit at the same rate. This is another
challenge for agriculture finance in agricultural credit delivery.
CHAPTER: 5

RECOMMENDATIONS

The agricultural credit institutions, to protect themselves from risks, should

classify the agricultural sector in terms of risk. The activities with higher loan
default rate because of any reasons should be kept in high-risk zone and activities
with lower loan default rate should be placed in low-risk zone. The financial
institution should first start lending in low-risk zones and then gradually go
towards high-risk zones.

Financial supervision should be strengthened and financial institutions should

keep provisions for loan losses higher than that of other sectors because
agriculture business is comparatively more risky. In this way institutions can
protect themselves against credit risk associated with agricultural finance.

The mind-set of borrowers also needs to be changed. The habitual defaulters

should be discouraged to get the loan or if disbursed then default. This mostly
happens in situations where the borrower does not use the loan amount for the
purpose he has acquired for. So the actual situation should be clear to the lender
by visiting and monitoring.

Diversification has always been a strategy to minimise risk. The same

diversification strategy should be adopted in agricultural finance and loan should
be disbursed to different activities of agriculture e.g. in farm business, non-farm
business, live stock etc. In this case if the borrower suffer losses in one side then
he would be earning profits on other side and would be able to repay his loan.

Similarly the repayment schedules should also be classified in such a way that is
convenient for individual borrower to repay his loan in easy instalments. This
will minimise the credit risk.
For minimising credit risk, information database should be there with the lender
about the credit history and credit worthiness of farmer-borrowers to help in loan
disbursement.

Appropriate collateral should be taken to minimise the risk of default in loans. In

this respect warehouse receipt is very appropriate. The warehouse receipt will
help farmer-borrower to use it as collateral in getting loan for agriculture purpose.

The market risk should be minimised by promoting diversified sources of income

for rural household so that if farmer suffer losses by selling his produced at lower
offer prices then he would be able to repay the loan from his other sources of
income.

Crops are mostly destroyed because of bad weather conditions or diseases that
cause the farmer losses. Crop insurance in this prospect is an excellent idea to
protect crops from unfavourable weather conditions.

In meeting the demands of international markets, farmers will need to produce

commodities according to international standards and qualities. Significant
changes in the production structure may be required in terms of enterprise choice
and the degree of specialisation, adjustments in farm size and integration of farm
production with farm input supply, agro-processing and marketing in the same
commodity chain. Such changes are easier for large rather than small farmers.
CONCLUSION

Agriculture sector is Pakistan is growing at upward trend because of increasing

population and this result in increase for credit needs by farmers for the their
agriculture activities but the credit disbursement by banks is not increasing at the
same rate to meet the farmers requirements.

Agriculture is a risky business. Both agricultural specialised financial institutions

and agricultural credit departments of commercial banks are greatly affected by
this and cause them with greater number of non-performing loans and lower profit
margin.

Agricultural lending projects have comparatively poor repayment performance

mainly because of the reason that agriculture business have greater exposure to
weather risk. Market and price are additional risks that are associated with
agricultural finance. Market and price risks are associated with agricultural
finance in the way that many agricultural markets are imperfect that lacks
communication infrastructure and access to the market. It cost a farmer higher to
take his crops to the market because of bad condition of roads, lack of information
and thus result them higher cost of the crops while they have to sell in the market
at competitive price.

In pure perfect market where international players freely enter into the local
market can ruin the local agriculture industry and cause local farmers difficulty in
repayment f their debts because of greater and powerful competition.

Operational risk is associated with agricultural finance in the sense that in case of
small farmer-borrowers spread over vast area, cost higher to serve. The cost of
servicing customers is higher than the profit earned from them. The financial
institutions face with liquidity risk in different seasons. In the cultivation season,
the financial institution faces with shortage of funds to lend out while after the
harvesting season, the financial institutions have excess of liquidity.
Credit risk associated with agricultural finance is influenced by cost and interest
rate margin. The financial institutions are also greatly influenced by political
interference especially in case of state-owned financial institution. Loan write-
offs increase the cost of lending for the financial institution.
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