Agricultural Lending

Other Credit Risk Management Options

Because farm commodities are subject to fluctuating market prices, extreme weather, and other perils that can jeopardize repayment, farm borrowers and bankers often use other methods to mitigate risk.

Government Programs. Various government programs may limit farm risk. As an example, by entering the Conservation Reserve Program, farmers contractually commit to limit crop production on certain portions of their land. The farmer receives annual payments established by bid at the inception of the contract.

Crop Insurance. As a risk management option, lenders may require or encourage use of crop insurance. Many farmers consider insurance as beneficial and as necessary as feed, seed, or fertilizer. Insurance is available to cover moderate and catastrophic losses of production caused by weatherrelated difficulties, such as hail and floods. In the event of crop loss, insurance will pay a percentage of crop value.

Forward Contracting. Producers often use contracts with packers or grain buyers to market their production. These contracts vary widely and have to be analyzed carefully as they sometimes can actually increase risks rather than mitigate them.

Hedging. Hedging can be a complex practice and is practiced generally by larger operations. The practice is used to mitigate the effect of market volatility through the buying or selling of futures contracts—legally binding commitments to sell or buy a commodity in the future at a previously determined price. Futures contracts for each type of commodity have standardized, non-negotiable features, such as quantity, quality, time of delivery, and place of delivery. Only the price component of a futures contract is negotiable. Most futures contracts do not result in delivery of the physical commodity. Instead, the contract’s delivery requirement is offset when the owner of a contract takes an equal and opposite position. For example, a projection of record harvests may give a farmer the incentive to sell a futures contract to lock in the price at which he can sell a particular commodity at a future date. Alternatively, a farmer wishing to protect against rapid price increases in the cost of feed may purchase a contract to take future delivery at a pre-determined cost.

Borrowing Base Certificates and Loan Covenants. Many farm lenders require protective covenants and other affirmative undertakings by the borrower as part of the loan underwriting process. Frequently, this includes establishing financial ratios and collateral margins that the borrower must maintain during the term of the loan. Such arrangements typically require the borrower to periodically provide the bank with a completed certificate attesting to compliance with collateral margins and other conditions. These controls aid the banker in detecting trends and early signs of credit deterioration. On some short-term operating lines, banks will in fact require the borrower to submit requests detailing the purpose of each advance against the approved line. This helps the bank ensure that funds are advanced only for approved purposes.

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