INNOVATIONS IN RURAL AND AGRICULTURE FINANCE


Credit Risk Management in Financing Agriculture MARK D. WENNER


FOCUS 18 • BRIEF 10 • JULY 2010 A


griculture is an inherently risky economic activity. A large array of uncontrollable elements can affect output


production and prices, resulting in highly variable economic returns to farm households. In developing countries, farmers also lack access to both modern instruments of risk management—such as agricultural insurance, futures contracts, or guarantee funds—and ex post emergency government assistance. Such farmers rely on different “traditional” coping strategies and risk-mitigation techniques, but most of these are inefficient. Formal and semiformal arrangements—such as contract farming, joint-liability lending, and value-chain integration—have arisen in recent decades, but they too are limited and can be very context sensitive. One consequence of inadequate overall financial risk management is that farmers in general face constrained access to formal finance. The smaller the net worth of the farm household, the worse the degree of exclusion. Formal lenders avoid financing agriculture for a host of


reasons: high cost of service delivery, information asymmetries, lack of branch networks, perceptions of low profitability in agriculture, lack of collateral, high levels of rural poverty, or low levels of farmer education and financial literacy. But, predominantly, bank managers around the world say they will not finance agriculture because of the high degree of uncontrolled production and price risk that confronts the sector. A farmer can be an able and diligent manager with an excellent reputation for repayment, guaranteed access to a market, and high-quality technical assistance, but an unexpected drought or flood can force him or her to involuntarily default. In emerging countries with fair to high levels of agricultural market and trade integration, large commercial farmers may escape this predicament because they have the ability to purchase insurance, engage in price hedging, obtain financing overseas, or liquidate assets quickly in the event of a default. Consequently, formal lenders tend to overemphasize the use of immoveable collateral as the primary buffer against default risk, which means they provide services to a limited segment of the farm population. Small- and medium-sized farmers, who constitute the vast majority of farm operators, often do not have secured-title land, which is the preferred type of collateral; if they do, its value may be insufficient to cover the loan in question. Even if farmers have sufficient titled land to collateralize loans, they may refuse low-interest formal loans and assume high-interest informal ones that have no collateral requirements instead. They may also use savings to finance agricultural production because they are averse to risking their most prized possession—land. The result is limited supply or access to formal agricultural financing, even though much of the population of Sub-Saharan Africa and South Asia is rural and depends on agriculture and livestock rearing for their main livelihood activities.


Typical risk-management mechanisms in rural financial intermediaries


In developing countries, formal and semiformal rural financial intermediaries have limited or nonexistent means to transfer credit


risk to third parties through, for example, portfolio securitization or credit insurance, which were common in mortgage and consumer finance markets in developing countries prior to the 2008 financial crash. If more farm borrowers held agricultural insurance policies, this could serve to reduce credit risk for financial institutions, but agricultural insurance markets are grossly underdeveloped in middle- and low-income countries. For example, agricultural premiums totaled US$18.5 billion worldwide in 2008, but the United States and Canada accounted for 62 percent of the premium volume. Latin American, Asian, and African regions, home to most of the lower-income countries, accounted for 21 percent, or US$3.88 billion. Moreover, the leading countries in terms of agricultural insurance development—the United States, Canada, and Spain—all depend on heavily subsidized schemes that would be difficult to replicate in other places. Thus, most of the strategies available to financial intermediaries in developing countries involve coping with and absorbing credit default risk. There are two broad means of evaluating creditworthiness: appraisal of repayment capacity and asset- backed lending. The former approach focuses on analyzing the debt-paying capacity of a potential borrower using either human experts or statistical models, while the latter focuses on the quality and quantity of assets that can be pledged as collateral and how quickly that collateral can be liquidated in the event of a default. Since titled assets are scarce outside of large farms and extensive databases on farm enterprises rarely exist in developing countries, the following represent the four credit risk-management techniques used successfully by rural financial intermediaries. Expert-based credit evaluation systems: Trained credit officials conduct financial analysis of the client, focusing on household cash flow, market situation, assessment of managerial or entrepreneurial ability, and reputation. Institutions can have centralized or decentralized systems to approve client requests as long as both systems include performance incentives for and investments in staff members, who should be recruited from the region of operations. To quickly determine client willingness to repay loans, staff members need access to credit bureaus or borrowers’ utility bill payments. Agriculture requires a wide range of experts since it is such a heterogeneous field; therefore, an expert-based evaluation system is expensive to both develop and maintain. Portfolio diversification: In order to dilute risk, intermediaries consciously seek to diversify the agricultural loans approved by geographic region, commodity, and type of household. This technique can be implemented only by large institutions that operate in more than one agroclimatic zone, however. Portfolio exposure limit: Because agricultural lending is risky


and expensive, high-performing financial intermediaries tend to limit exposure to agriculture in their loan portfolio. For example, recent survey data in Latin America found that the average share is less than 40 percent. The smaller the share agriculture has in a total loan portfolio, the less vulnerable the institution is to systemic external


FOR FOOD, AGRICULTURE, AND THE ENVIRONMENT


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