Agricultural Lending

Credit Risk

Credit risk is the most significant risk associated with agricultural lending. A farmer’s production and ability to service debt can be affected seriously by weather conditions and other natural factors not directly under the farmer’s control. Moreover, agricultural markets are sensitive to highly variable supply and demand conditions in world markets that may directly or indirectly affect both the borrower’s repayment capacity and the value of the bank’s collateral.

Aside from weather conditions, the most significant variables affecting agricultural credit risk are market prices and government policies. Other important factors include concentrations and limited-purpose collateral.

Market prices. Market prices pose the risk of loss to farmers from unforeseen input or output price changes. Examples include unexpected expenses for feed, fuel, and fertilizer (input), or depressed prices due to record crops (output). Farmers may mitigate the risk of losses from price fluctuations by numerous methods, including diversifying their crop and livestock activities, hedging commodities under production, and contracting (pre-selling) production.

Government agricultural policies. Historically, federal price support programs have reduced price volatility for program crops. However, the Federal Agriculture Improvement and Reform Act of 1996 (Farm Bill) included significant changes to crop subsidy programs. Among other things, the Farm Bill phases out crop subsidies over a seven-year period. Eligible farmers will get fixed, sliding-scale payments through 2002. Fundamentally, the Farm Bill will eliminate price protection for several crops and shift to farmers greater risk for market price volatility.

Concentrations. Agricultural loan concentrations occur naturally when banks are located in communities with agriculture-dependent economies. For many individual agricultural banks, concentration risk is high. In addition to concentrations in crop and livestock loans, other farm-related assets can form concentrations. For instance, banks may also lend to companies that deal exclusively with agricultural enterprises, such as seed companies, grain elevators, and farm machinery dealers. Additionally, they may invest in securities from agencies participating in the government’s agricultural lending programs.

Limited-purpose collateral. Agriculture-related collateral affects credit risk because it may have few or no alternative uses to support values when loan repayment problems arise. For example, a broiler house may have very little residual value when a borrower loses a contract with a poultry concern. Additionally, commodity prices and land values are sometimes highly correlated, especially in agricultural regions where farm land has no alternative productive use when commodity prices fall to a level that is inadequate to repay debt. In regions that contain substantial multi-use properties, however, there may be minimal correlation between land values and commodity prices.

Appraisers commonly evaluate farm collateral based on market value, not liquidation value, and this too, can affect collateral values. This practice is normal; however, in distressed situations, liquidation values can deviate dramatically from market values, causing significant differences between collateral value and outstanding loan balances.

Because of correlations among agricultural risk factors, stress testing can be an important part of a bank’s risk management process. (Refer to the ”Loan Portfolio Management” booklet for more information about stress testing.)

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