Diversification to Remain a Core Element of Risk Management

Diversification is and will remain one of the primary risk mitigation strategies used by microfinance institutions and rural banks engaged in agricultural lending. For financial institutions, agricultural lending cannot be the primary type of lending unless robust risk transfer techniques become more commonplace, especially for small and marginal farmers. Financial institutions must counter unrealistic expectations and withstand political pressure to engage non-prudently and excessively in agricultural lending. Under a prudent financial sector approach finance follows the real sector. Hence, the share of value added in agriculture as percent of GDP may serve as a benchmark for financial institutions' exposure to agriculture. According to the World Bank, in 2008 the average share of agriculture was 7 percent in Latin America, about 12 percent in most of East Asia and Sub-Sahara Africa, and 18 percent in South Asia. Hence, setting a ceiling on the share of agricultural loans between 10 percent and 30 percent of a loan portfolio, depending on the region, seems plausible and prudent.

In addition, diversified portfolios of the financial institutions must be complemented by risk diversification by the farmers themselves. Only a small share of the smallholders will grow and emerge as specialized commercial farmers, but the large majority of small farmers will likely remain family or household enterprises. For these, risk mitigation through diversification of income sources will remain a key risk management strategy. Successful agricultural lenders will look more closely at the risk retention layer and analyze the farmer's own risk management capacity in terms of prevention, mitigation, and coping strategies as a factor of creditworthiness. Precautionary savings play a crucial role and thus it is essential that safe, convenient, and accessible savings facilities are offered by financial institutions.

Improvements in Legal Framework and Financial Infrastructure

In most countries, improvements in the legal and regulatory frameworks are necessary as they pertain to agriculture and agricultural finance. This encompasses systems of clear property rights and especially improved cadastre systems related to land ownership and registry. Another key element is a strong legal framework for secured transactions. Such framework should particularly include a collateral registry for movable assets that would allow farmers to pledge equipment and machinery as collateral as well as facilitate leasing of agricultural equipment. Expanding the collateral options would greatly improve farmers' access to credit, on the one hand, and financial institutions' risk management, on the other hand.

 
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