InnovatIons In RuRal and agRIcultuRe FInance

Credit Risk Management in Financing Agriculture

Mark D.Wenner
Focus 18 BrieF 10 July 2010
FOR FOOD, AGRICULTURE, AND THE ENVIRONMENT

gricultureisaninherentlyriskyeconomicactivity.Alarge arrayofuncontrollableelementscanaffectoutput productionandprices,resultinginhighlyvariableeconomicreturns tofarmhouseholds.Indevelopingcountries,farmersalsolack accesstobothmoderninstrumentsofriskmanagementsuchas agriculturalinsurance,futurescontracts,orguaranteefundsand expostemergencygovernmentassistance.Suchfarmersrely ondifferenttraditionalcopingstrategiesandrisk-mitigation techniques,butmostoftheseareinefficient.Formalandsemiformal arrangementssuchascontractfarming,joint-liabilitylending,and value-chainintegrationhaveariseninrecentdecades,butthey tooarelimitedandcanbeverycontextsensitive.Oneconsequence ofinadequateoverallfinancialriskmanagementisthatfarmersin generalfaceconstrainedaccesstoformalfinance.Thesmallerthe networthofthefarmhousehold,theworsethedegreeofexclusion. Formallendersavoidfinancingagricultureforahostof reasons:highcostofservicedelivery,informationasymmetries,lack ofbranchnetworks,perceptionsoflowprofitabilityinagriculture, lackofcollateral,highlevelsofruralpoverty,orlowlevelsoffarmer educationandfinancialliteracy.But,predominantly,bankmanagers aroundtheworldsaytheywillnotfinanceagriculturebecause ofthehighdegreeofuncontrolledproductionandpriceriskthat confrontsthesector.Afarmercanbeanableanddiligentmanager withanexcellentreputationforrepayment,guaranteedaccessto amarket,andhigh-qualitytechnicalassistance,butanunexpected droughtorfloodcanforcehimorhertoinvoluntarilydefault.In emergingcountrieswithfairtohighlevelsofagriculturalmarket andtradeintegration,largecommercialfarmersmayescapethis predicamentbecausetheyhavetheabilitytopurchaseinsurance, engageinpricehedging,obtainfinancingoverseas,orliquidate assetsquicklyintheeventofadefault.Consequently,formal lenderstendtooveremphasizetheuseofimmoveablecollateralas theprimarybufferagainstdefaultrisk,whichmeanstheyprovide servicestoalimitedsegmentofthefarmpopulation.Small-and medium-sizedfarmers,whoconstitutethevastmajorityoffarm operators,oftendonothavesecured-titleland,whichisthe preferredtypeofcollateral;iftheydo,itsvaluemaybeinsufficient tocovertheloaninquestion.Eveniffarmershavesufficienttitled landtocollateralizeloans,theymayrefuselow-interestformalloans andassumehigh-interestinformalonesthathavenocollateral requirementsinstead.Theymayalsousesavingstofinance agriculturalproductionbecausetheyareaversetoriskingtheirmost prizedpossessionland.Theresultislimitedsupplyoraccessto formalagriculturalfinancing,eventhoughmuchofthepopulation ofSub-SaharanAfricaandSouthAsiaisruralanddependson agricultureandlivestockrearingfortheirmainlivelihoodactivities.

Typical risk-management mechanisms in rural financial intermediaries

Indevelopingcountries,formalandsemiformalruralfinancial intermediarieshavelimitedornonexistentmeanstotransfercredit

risktothirdpartiesthrough,forexample,portfoliosecuritizationor creditinsurance,whichwerecommoninmortgageandconsumer financemarketsindevelopingcountriespriortothe2008financial crash.Ifmorefarmborrowersheldagriculturalinsurancepolicies, thiscouldservetoreducecreditriskforfinancialinstitutions, butagriculturalinsurancemarketsaregrosslyunderdeveloped inmiddle-andlow-incomecountries.Forexample,agricultural premiumstotaledUS$18.5billionworldwidein2008,butthe UnitedStatesandCanadaaccountedfor62percentofthepremium volume.LatinAmerican,Asian,andAfricanregions,hometomostof thelower-incomecountries,accountedfor21percent,or US$3.88billion.Moreover,theleadingcountriesintermsof agriculturalinsurancedevelopmenttheUnitedStates,Canada, andSpainalldependonheavilysubsidizedschemesthatwouldbe difficulttoreplicateinotherplaces. Thus,mostofthestrategiesavailabletofinancialintermediaries indevelopingcountriesinvolvecopingwithandabsorbing creditdefaultrisk.Therearetwobroadmeansofevaluating creditworthiness:appraisalofrepaymentcapacityandassetbackedlending.Theformerapproachfocusesonanalyzingthe debt-payingcapacityofapotentialborrowerusingeitherhuman expertsorstatisticalmodels,whilethelatterfocusesonthequality andquantityofassetsthatcanbepledgedascollateralandhow quicklythatcollateralcanbeliquidatedintheeventofadefault. Sincetitledassetsarescarceoutsideoflargefarmsandextensive databasesonfarmenterprisesrarelyexistindevelopingcountries, thefollowingrepresentthefourcreditrisk-managementtechniques usedsuccessfullybyruralfinancialintermediaries. Expert-based credit evaluation systems:Trainedcredit officialsconductfinancialanalysisoftheclient,focusingon householdcashflow,marketsituation,assessmentofmanagerial orentrepreneurialability,andreputation.Institutionscanhave centralizedordecentralizedsystemstoapproveclientrequests aslongasbothsystemsincludeperformanceincentivesforand investmentsinstaffmembers,whoshouldberecruitedfromthe regionofoperations.Toquicklydetermineclientwillingnesstorepay loans,staffmembersneedaccesstocreditbureausorborrowers utilitybillpayments.Agriculturerequiresawiderangeofexperts sinceitissuchaheterogeneousfield;therefore,anexpert-based evaluationsystemisexpensivetobothdevelopandmaintain. Portfolio diversification:Inordertodiluterisk,intermediaries consciouslyseektodiversifytheagriculturalloansapproved bygeographicregion,commodity,andtypeofhousehold.This techniquecanbeimplementedonlybylargeinstitutionsthat operateinmorethanoneagroclimaticzone,however. Portfolio exposure limit:Becauseagriculturallendingisrisky andexpensive,high-performingfinancialintermediariestendtolimit exposuretoagricultureintheirloanportfolio.Forexample,recent surveydatainLatinAmericafoundthattheaverageshareisless than40percent.Thesmallertheshareagriculturehasinatotalloan portfolio,thelessvulnerabletheinstitutionistosystemicexternal

shocksthatcouldseverelydepressearningsperformanceandthe morecross-subsidizationcanoccur.High-marginfinancialproducts suchasconsumerfinanceandurbanmicrofinancecancompensate forlowerprofitmarginproducts,suchasagriculturalloans. Excessive provisioning: Thelastlineofdefenseiscalled loanlossprovisioning,meaninganinternalabsorptionofcredit risk.Adequateprovisioningaccordingtoarisk-classification schemehelpstoprotecttheintermediaryfromliquidityandcapital adequacycrises.SomeleadingagriculturallendersinLatinAmerica, forexample,provisionfrom121to260percentofdoubtfulloans. Heavyprovisioning,however,clearlyconstrainsthevolumeof lending,abilitytomakeaprofit,andclientoutreachpotential.

diversificationthroughmobilizationofsavings,accesstocapital markets,andtheprovisionoflong-termlinesofcreditthatcould facilitatemoretermlending.Nevertheless,donorsandgovernments mustpricethediscountlineofcreditsinamannerthatwillnot underminesavingsmobilization.

Conclusion
Inshort,riskmanagementneedstoimprovedramaticallysothat agriculturalfinancecanflourish.Strideshavebeenmadeinrecent yearsinreducinginformationproblemsandtransactioncosts through,respectively,peer-grouplendingandagreaterrelianceon informationandcommunicationtechnology.Uncontrollablerisk, however,continuestobeamajorimpedimenttothedevelopment ofmoreefficientruralfinancialmarkets.Renewedprivatepublic sectoreffortsandhigheramountsofinvestmentswillberequired atvariouslevelstoaddresstheseissues.Atthefarmerlevel, governmentsneedtospurtherebuildingoffarmextensionservices, whilefarmersneedtobecomemorefinanciallyliterateandsave moresotheycanretainsomeoftherisks.Governments,donors, andinsurancecompaniesneedtocollaborateinthedevelopment ofyield-insuranceproductsthatareinexpensive,sustainable,and appropriatelydesigned.Governments,commodityexchanges,and financialinstitutionslikewiseneedtocollaborateindeveloping futures,structuredfinanceproducts,andotherhedginginstruments toreducepricerisk. Atpresent,thelackofhigh-qualityweatherdata,inadequate distributionofweatherstations,limitedsupplyofpeoplewithriskmodelingcapabilitiesandexpertiseinagriculturalriskmanagement, smallcapitalmarkets,andweaknessesinregulatoryandlegal infrastructurehamperthepaceofprogress.Sincethedepthand efficiencyoffinancialmarketsarehighlycorrelatedwiththespeed ofoveralleconomicdevelopment,innovativemethodsofimproving ruralfinancialserviceswillbecriticalinfacilitatingandsustaining anymarkedimprovementinruralwelfare.n
For further reading: H. Bhattacharya, Banking Strategy, Credit Appraisal and Lending Decisions: A Risk-Return Framework, (New Delhi, India: Oxford University Press, 1996); J. B. Caoutte, E. I. Altman, and P. Narayanan. Managing Credit Risk: The Next Great Financial Challenge, (New York: John Wiley and Sons, Inc., 1998); C. Trivelli, and A. Tarazona, Riesgo y Portafolios Agropecuarios: Lecciones desde la Experiencia de Instituciones Financieras de Amrica Latina, Documento de Trabajo 151 (Lima, Per: Instituto de Estudios Peruanos, 2007), www.iep.org.pe/textos/DDT/DDT151.pdf; M. Wenner, S. Navajas, C. Trivelli, and A. Tarazona, Managing Credit Risk in Rural Financial Institutions in Latin America, Sustainable Development Department Best Practices Series MSM 139 (Washington, D.C.: Inter-American Development Bank, 2007); World Bank, Doing Business database, www. doingbusiness.org/economyrankings.

Implications for managers of financial institutions and public policymakers

Therearenumerousimplicationsofthesecreditrisk-management techniques.First,thecreditriskevaluationsystemsarelabor intensivewithhighcosts,which,inturn,contributetohighlending interestrates.Public-sectorpolicymakersneedtounderstandthis, sotheyavoidimposinginterestrateceilingsorforcingpublicly ownedbankstochargeinterestratesthatarelowerthantheirtrue operatingcostsbecauseresultswouldthenbecounterproductive. Additionally,fewerintermediarieswouldbewillingorabletoserve thesector.Therefore,bothpolicymakersandmanagersshouldfocus ondevelopingandimplementinginstitutionalinnovationssuch ascreditbureaus,applicationsofinformationandcommunication technology,anddelegatedagentmodelsofservicedeliverythat willreduceoveralloperatingcosts. Second,agriculturallendingcannotbetheprimarytype oflendingunlessrobustrisk-transfertechniques(forexample, insurance,futures,andsecuritization)becomemorecommonplace. Inplaceofland,alternativeformsofcollateralincludingwarehouse receipts,accountsreceivable,equipment,andstandingcropsor livestockshouldbemorewidelyaccepted.Improvedcontract enforcementshouldbeaggressivelypromotedaswell.These developmentswouldallservetolowerlenderrisk.Manyofthese innovationsandinstitutionaldevelopmentsrequirelegaland regulatoryreforms,modernizationofpropertyregistries,investments ininformationinfrastructure,andmassiveeducationefforts. Third,themajorityofinstitutionsinvolvedinagricultural lendingaresmallandunregulated.Theyareusingadapted microcredit-lendingtechnologiesthatdonotfullymeetthe needsoffarmers,especiallythoseneedsregardingloantermand repaymentfrequencies.Theseshortcomingsposedefaultrisksin andofthemselves.Thelargerinstitutionsthathavethescaleand scopetendnottoenterintoagriculturallendingbecausethey donothavethestrategiccommitment,properstaff,orbranch networks.Donorsandgovernmentscanplayavitalroleinassisting thesesmallerinstitutionstogrow,consolidate,andeventually merge.Theycanalsohelpruralfinancialintermediarieswithliability

Mark D. Wenner (markw@iadb.org) is a lead financial specialist in the Capital Markets and Financial Institutions Division of the Inter-American Development Bank.

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