Innovations in Rural and Agricultural Finance: Credit Risk Management in Financing Agriculture
Agriculture carries with it a number of inherent risks. Weather, pests and crop disease, and variable local and global markets are all out of a farmer’s control, making it difficult to generate stable income. While farmers in developed countries and large-scale farmers in emerging economies can hedge these risks through the use of credit, insurance, and other financial instruments, developing country farmers typically rely on more “traditional”, and less effective, risk management techniques because they lack access to formal financing options.
Many banks hesitate to finance smallholder agriculture in developing countries because of the high cost of delivering services to rural areas, information asymmetries, a lack of branch networks, perceptions about agriculture’s low profit potential, small farmers’ lack of collateral, high levels of rural poverty, and low levels of farmer education and financial literacy. In a recent IFPRI 2020 Vision Focus Brief, researcher Mark Wenner analyzes several credit techniques that rural financial intermediaries in developing countries typically use to cope with and absorb farmers’ credit default risk.
- **Expert-based credit evaluation systems**: These systems use trained credit officials to conduct a financial analysis of the farmer’s situation, focusing on household cash flow, market situation, and assessment of the farmer’s managerial or entrepreneurial ability and reputation. This evaluation would provide lenders with more information about potential clients, making it easier for them to determine farmers’ creditworthiness. [IFPRI’s risk-scoring system](http://www.ifpri.org/publication/parametric-versus-nonparametric-methods...), implemented in Peru, provides a solid example of an expert-based evaluation system. One drawback to this option, however, is that because agriculture is such a complex sector, it requires a wide range of experts; therefore, such a system would be expensive to develop and maintain.
- **Portfolio diversification**: Diversifying loans by geographic region, commodity, and type of household can help intermediary organizations dilute risks. However, this technique is typically limited to large institutions that operate in more than one agroclimatic zone.
- **Portfolio exposure limit**: Because agricultural lending is both risky and expensive, many financial intermediaries tend to limit their exposure to agriculture in their loan portfolio. The smaller the share or agriculture in a total loan portfolio, the less vulnerable the institution is to systemic external shocks. High-margin financial products— such as consumer finance and urban microfinance—can compensate for lower profit margin products, such as agricultural loans.
- **Excessive provisioning**: “Loan loss provisioning” means internal absorption of credit risk; when used appropriately according to a risk-classification scheme, this can help protect the intermediary from liquidity and capital adequacy crises. However, too much provisioning will constrain an intermediary’s volume of lending, ability to make a profit, and client outreach potential.
According to Wenner, these techniques carry several implications for financial institutions and policymakers interested in increasing finance for development. First, the operating costs for many of these strategies, particularly evaluation systems, are high, leading to higher interest rates. Reducing these costs through the development of credit bureaus, ICT applications (taking into account certain constraints), and the use of agents to deliver services should be a focus for both policymakers and managers of financial institutions. Second, financial institutions must become more willing to accept other forms of collateral besides land, such as warehouse receipts or equipment; in addition, contract enforcement efforts should be ramped up to prevent non-compliance by both producers and buyers. Both of these recommendations will require improvements in many countries’ regulatory environments, as well as investments in information infrastructure and farmer education. Finally, small financial institutions make up the majority of lenders in developing countries; these are often unregulated and often cannot meet farmers’ needs. Donors and governments should focus on helping these institutions grow and merge in order to provide more complete services.
Significant investment and effort will be required to overcome the challenges facing financial markets in developing countries. However, improving rural financial services is critical in improving rural welfare and speeding up overall economic development.