The major factors that affect banker and farmer behavior in on-farm lending operations are the expected profitability of and the risks related to on-farm investments. Risks can be of different natures and include those associated with the impact of unfavorable weather on production [drought, hail, floods etc] diseases and pests 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 utilization of financial resources and the repayment behavior 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 and under dry farming conditions. These risks will decrease as the level of education of farmers and availability of information on markets, prices and loan repayment behavior increase. Additionally, agricultural insurance may be useful as a risk management tool, especially for relatively high technology farming that involves significant investment. This can be used only for specific crop/livestock enterprises and for clearly defined risks.

Risks are also related to 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-worthy resources in deposit-taking financial institutions, and considering the time horizon of agricultural seasonal and investment loans, commercial banks 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-worthy resources and apply measures to protect their loan portfolio from potential risk losses.

Additional risk protection measures that present added costs to borrowers include insurance coverage against insurable risks such as specified adverse weather events leading to crop damage or insurance against fire [buildings and crops] and theft [moveable assets] Government or donor financed loan guarantee schemes, in general, have not led to significantly increased lending [additionally] and they should be carefully designed in order to secure appropriate risk management and sharing as well as cost effective administration. On the other hand, mutual guarantee associations have proven their usefulness. Banks also control their financial exposure by limiting their loans to only a portion of the total investment costs and by requiring that the borrower engages sufficient equity as well as careful diversification of their loan portfolio in terms of lending purposes, market segments and loan maturities. Portfolio diversification is a key to sustainability and successful risk management.

Institutional Risks

Financial institutions face four major risks

1. Credit or loan default risk refers to borrowers who are unable or unwilling to repay the loan principal and to service the interest rate charges.

2. Liquidity risk-occurs when a bank is not able to meet its cash requirements. Mismatching the term of loan assets and liabilities [sources of loan-worthy funds] exposes banks to high liquidity risks.

3. Interest rate risk- risk that a loan will decline in value as interest rate change

4. Foreign exchange risk- defines exposure to changes in exchange rates which affect international borrowings denominated in foreign currency.

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 extremely difficult to predict. They can have serious consequences for income generation and for the loan repayment capacity of the borrowing farmers. 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.

Agricultural lending implies high liquidity risks due to 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 agricultural loan portfolio. As a result, the provision of viable, sustainable financial services and the development of a strong rural financial system are contingent on the ability of financial institutions to assess, quantify and appropriately manage various types of risks.

Production and yield risks

Yield uncertainty due to natural hazards refers to the unpredictable impact of weather, pests and diseases, and calamities of farm production. Risks severely impact younger, less well established, but more ambitious farmers. Especially affected are those who embark on faming activities that may generate a high potential income at the price of concentrated risks such as in the case of high input monoculture of maize. Subsequent loan defaults may adversely affect the credit worthiness of farmer borrowers and their ability to secure future loans.

Market and price risks

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. The relatively long time period between the decision to plant a crop or to start a livestock enterprise and the realization of farm output means that market prices are unknown at the moment when a loan is granted. This problem is even more acute in tree crops because of the gap of the 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 parasitical body. These organizations announced a buying price before planting time. Many disappeared following structural adjustments reforms and privatization of agricultural support services. Private buyers rarely fix a blanket-buying price prior to the harvest, even though various interlinked 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.

Risk of loan collateral limitations

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 often prized by owners above its market value and it has a high scarcity value in densely populated area. 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 programs limits its value as collateral –even when 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 programs.

Moral hazard risks in distorted credit culture

Potentially serious risk problems are showing up because of failed directed credit programs. 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 concessionary 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 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 “concessionary” 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.

Risk from changes in domestic and international policies

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 the structural adjustment program have slashed their farming subsidies. This has had, for instance, a serious effect on the costs and the demand for fertilizer. Reducing government expenditures as an essential part of structural adjustment programs may also affect employment opportunities in the public sector. Costs may even reduce agricultural production levels, if extension services are suddenly discontinued.

While above risk factors have significant impact on banks’ inability to widen and deepen the credit outreach more particularly in dry-land. Drought prone, desert, tribal and hilly areas following policy issues have further created adverse impact on banks to cover small/marginal/ tenant farmers, oral lessees, share croppers. 

Directed Credit

Since the early1950s government and donors have spent large amounts on agricultural credit programs in developing countries. The World Bank alone committed over US $ 16 billion to these efforts from the mid-1950s to the late 1980s and other donors also spent substantial amounts. In several countries such as Brazil, India, Indonesia, Mexico and Sri Lanka, supply-led and directed credit programs were the dominant tools used to spur agricultural development during the three decades prior to the 1990s. In centrally planned countries directed lending was likewise a prominent instrument used to implement agricultural production plans. However, directed credit programs still continue to play a strong role in some developing countries viz. Philippines, India etc.

The assumption behind these efforts was that many farmers faced liquidity constraints that limited their ability to make farm investments and to use additional modern inputs. Relaxing these constraints by providing them with loans, therefore, was thought to be an easy way of stimulating farm investments, boosting the use of modern inputs and augmenting farm production.

The proponents of the directed credit approach assign many tasks to financial markets on the one hand, but on the other hand pay little attention to providing and maintaining the financial infrastructure needed to carry out these assignments. In contrast, the new market approach assigns more modest role to financial markets. The new approach stresses the importance of the processes of financial intermediation. The principal goal in improving this process is to enhance the efficiency of resource allocation in the economy. This is done by efficiently mobilizing deposits from savers who otherwise, have only low-return options for investing their surplus funds, and then efficiently allocating loans to creditworthy borrowers who have too few funds to capitalize on viable investment opportunities.

The users of financial services in a system strongly influenced by directed credit tend to be borrowers rather than depositors; the system is borrower dominated. By contrast, the new approach stresses the importance of mobilizing local deposits, and efficiently intermediating between savers and borrowers. In India while commercial and regional rural banks mobilize savings, Primary Agricultural Credit Societies are not allowed to mobilize rural savings even from their borrowers. Both commercial and regional rural banks have yet not developed saving mobilization instruments/products best suited to rural areas.

Typically, the volume of information associated with directed credit programs is substantial. Managers of directed credit programs are able to provide detailed information or data required by funds providers, but are unable to generate critical up-to-date management information, such as the status of loan recovery at any point of time. While banks in India have to collate, compile and furnish data under agricultural credit programs in the form of several returns periodically, leaving practically very little time for business development, return on recovery of loans is annual that does not provide status of recovery/over due at any point of time.

To justify subsidies associated with directed credit programs, it is common for credit planners to require that credit impact studies be done on these programs. These studies usually require collection and analysis of costly primary data that is not ordinarily assembled by lenders. The cost of managing the dense volume of information generated by directed credit activities typically augments loan transaction costs for both lender and borrower.

In contrast, the new approach generates less but more useful data. The absence of numerous directed credit lines eliminates the need to process data for each sub-program and make staff available for development of business including recovery mobilization.

Since the new approach stresses making loans based on creditworthiness of borrowers and projects, rather than on the basis of need, there is likewise much less data processed on the characteristics of borrowers and the impact of these programs. The essence of data collection and processing under new approach is to manage financial intermediaries efficiently and prudently. The performance of financial institution is measured by indicators such as deposit mobilization, transaction costs, loan recovery, number of clients, and financial and operational sustainability.

The support for these traditional directed agricultural credit efforts began to wane in the 1980s and by the end of the decade most donors and some Governments sharply reduced their support to agricultural credit. In part, this decline in support was due to the unsatisfactory performance of these efforts. Critics increasingly argued that relatively few of the credit subsidies were captured by poor people and that subsidized and directed credit had a weak effect on farm production and investment. Serious and chronic loan recovery problems, dependency on outside funding, and overall costs eroded the support for these efforts. Poor performance and the lessening of donor and Government support led to the collapse of many public agricultural development banks and [Government directed] rural cooperatives in the 1980s. In some countries like Peru and Bolivia traditional agricultural banks were closed down. In other countries such as The Gambia and ex-USSR all or part of the development banks were sold or privatized. Still in other countries these development banks and rural credit cooperatives persist but their financing activities have been sharply reduced, such as in Guatemala, Nicaragua and Uganda. In India where directed credit and Government sponsored programs still persist, commercial/cooperative banks and regional rural banks face serious problems of recovery of dues and had to be re-capitalized whereas co-operative banks are now being considered for re-capitalization.

Subsidized Interest Rate

The proponents of directed credit argue by justifying an interest rate subsidy on loans for people because they are poor, and justifying loan waiver/write off because poor borrowers later turned out to be “too poor” to repay the loans.

Under the new approach there are no subsidies associated with loans so there are no favors associated with lending. Financial intermediaries treat their borrowers and depositors as valued clients if they are to stay in business. This forces intermediaries to be attentive to the quality of services they provide, to the transaction costs they impose on their clients and to financial innovations that reduce these costs.

It was further assumed that most farmers were too poor to save, that informal financial markets were dominated by monopolist money lenders who charged usurious interest rates, and that commercial banks were too conservative to lend to most farmers. Based on these assumptions Governments and donors developed and funded numerous directed credit programs around the world. Most of these efforts were heavily subsidized by charging reduced interest rates or tolerating loan defaults.

A common arrangement for providing rural financial markets with donor or Government funds was to open reduced rediscount windows in the country’s central banks to disburse funds to selected groups, regions or activities. Banks and other financial institutions were stimulated to grant targeted lending by making cheaper debt funds available from the rediscount window. The interest rates on these funds were typically lower than the rates lenders were paying for alternative sources of funds. In the later, 1970s, for example, the central bank in Indonesia administered nearly 200 directed credit lines, many of which were aimed at agricultural activities, and most of which were subsidized. In India National Bank has been providing refinance at lowered interest rate to the banking system for farm and non-farm sector development. In fact, National Bank’s financial resources need to be deployed directly for long term investment purpose in developing irrigation potential, horticultural and plantation projects, establishing agro-processing units, cold chains, markets etc.

In some cases, the availability of rediscount funds was augmented by imposing loan portfolio requirements on commercial banks, as for example in India stipulated agricultural lending at 18% of net bank credit and un-lent portion to be lent for Rural Infrastructure Development Fund at a lower rate of interest to National Bank. These requirements were intended to compel banks to either make more loans for purposes targeted by Government, or to lend on more benign terms to other institutions, especially agricultural development banks that were doing targeted lending. In Thailand, for example, during the 1970s and 1980s the Government required all banks to lend an increasing percentage of their total loan portfolio to farmers. If they were unable to comply directly with this requirement, they were allowed to fulfill their obligation by lending money at discounted interest rates to the Bank for Agriculture and Agricultural Cooperatives. In some countries subsidized loan guarantee schemes were also established to further encourage agricultural lending, as for example in India Deposit Insurance and Credit Guarantee Scheme was established in early 1970s. The assumption behind these schemes was that by transferring part or all of the loan recovery risk to the insurance program, lenders would be induced to do more of the lending preferred by policy makers.

These subsidies take the form of discounted lower interest rate on funds provided to lenders, subsidized interest rates on loans made to beneficiaries, implicit subsidies involved in loans that are not repaid and written off, Government or donor grants to cover costs of institution involved in directed credit, and subsidies for supporting loan guarantee schemes.

An important objective of new approach is to eliminate subsidies in rural finance. Form of subsidies, if any, should be temporary and transparent and not linked to the lending activities but rather to institution building. To help reduce transaction costs, for example, training of bank staff in new lending practices or for banking operations and automation may be subsidized.

Since financial institutions are not processing subsidies under the new approach, they are much less susceptible to rent seeking and corruption, common features of the directed credit approach.

As part of this process, many countries formed or expanded agricultural development banks to handle the bulk of the targeted lending. In many countries political considerations were involved in loan approval and recovery decisions. Government mandated loan forgiveness in Bangladesh and Loan Mela and loan write-offs in India during 1980s being examples of such political interventions in financial sector operations.

Shifts in political priorities and donor preferences have often resulted in substantial changes in roles assigned to rural financial markets. Sometimes farm production and farm investments were stressed, while at other times poverty alleviation, pacifying the countryside, or disaster relief were the primary objectives of directed credit efforts, as for example in India provision of targeted and sub-targeted credit under the Integrated Rural Development Program focusing on direct attack on rural poverty from 1978 and provision of credit on soft terms to existing borrowers when natural calamities visit them in certain geographical areas.

Conclusion

While our research institutions must focus their attention to evolve technology to mitigate risks, it is high time that India must develop sustainable Agricultural Insurance Scheme and related insurance products that can help farmers significantly minimize incidence of income loss. Besides, State Governments must concentrate on creating infrastructure that can sustain agricultural development. The Reserve Bank of India should develop incentives for commercial banks to lend to the agricultural sector and mobilize rural savings.