The Potential of Structured Finance to Foster Agricultural Lending in Developing Countries

Peter Hartig[1], Michael Jainzik[2], and Klaus Pfeiffer[3]

Introduction

Three out of every four poor people in developing countries live in rural areas; 2.1 billion of them live on less than two U.S. dollars a day and 880 million on less than one dollar a day. Most of these people depend on agriculture for their livelihoods.[4] One of the major bottlenecks of agricultural development and rural growth is the lack of access to finance, a result of perceived high risks and costs involved in agricultural lending, among other financial services. Banks and other financial institutions in developing countries are still very reluctant to finance agricultural producers and, in particular, small farmers.

As a consequence, for example in various African countries, less than one percent of the available domestic private sector financing typically goes to agriculture, while agriculture accounts for up to 70 percent of the labor force in these countries.[5]

The aim of this chapter is to explore whether structured finance (SF) has the potential to overcome some of the impediments of agricultural lending in developing countries by mitigating specific risks associated with lending to agriculture. Such risk mitigation is possible by sharing, pooling, transferring, and diversifying the various risks.

We start with a broad definition of the term SF, and definitions of agricultural lending and agricultural value chain finance. Then we present typical agricultural risks and risk management strategies including the potential role of SF. Afterwards, we analyse various SF products that foster agricultural lending. The chapter closes with the limitations and important pre-conditions of SF in agriculture in developing countries.

Concept of Structured Finance

SF is not a concise term nor is there a universal definition. Depending on where it is applied, the term covers a wide range of financial market activities and instruments. Typically, SF is understood as a flexible financial engineering tool that can be “employed whenever the requirements of the originator or the owner of an asset, be they concerned with funding liquidity, risk transfer, or other need, cannot be met by an existing off-the-shelf product or instrument. Hence to meet these requirements, existing products and techniques must be engineered into a tailormade product or process.”[6]

Discussion and practice in development finance, for example in the context of providing refinancing to microfinance institutions (MFIs), is primarily focused on securitization and structured funds. Both apply the principle of pooling, diversifying, and tranching assets into different asset classes according to their respective (presumed) risk profile.[7]

In agricultural finance literature, SF is customarily defined broadly: “Structured finance for agriculture and agribusiness is the advance of funds to enterprises to finance inputs, production and the accompanying support operations, using certain types of security that are not normally accepted by banks or investors and which are more dependent on the structure and performance of the transaction, rather than the characteristics (e.g. creditworthiness) of the borrower.”[8] Thus, in agricultural finance literature, there is a focus on securities (i.e. collateral) in order to reduce credit risk, rather than on other aspects like risk transfer, liquidity, etc.

As far as the authors' understanding of SF is concerned, the application of SF in whatever form follows one major goal: the financial risk of an investment in a pool of diversified assets (e.g. loans), or the set of different unseparated risks connected with such an investment are decomposed into different types of risks or classes of risk (probability of occurrence). This is done by using special technical and legal tools in order to allow different investors (or risk carriers) to invest precisely in a certain type of risk, which they are best prepared or willing to invest in.

Following this definition, the different forms of SF can be analysed by asking three questions (see Figure 2 below). We will use these questions later as a grid for filtering out suitable SF approaches for agriculture finance.

Structuring Process

Outcome

Segmentation of various investment risks

Segmented types of risk

Defined levels and classes of risk

Allocation and placement of risks

Investment in a specific risk or risk tranche by the most appropriate party based on its

x Understanding and assessing of the risks

x Capacity to influence probability of occurrence of certain types of risk

x Risk carrying capacity

Fig. 1. The Essence of Structured Finance

Fig. 2. Analytical Grid of Structured Finance

Since agricultural lending is carrying sector-specific risk and is perceived to carry higher risks than lending to other sectors, the risk segmenting and transferring approach of SF makes it, in principle, appropriate and promising for agricultural lending.

  • [1] Consultant.
  • [2] Director KfW Office Windhoek.
  • [3] Director KfW Office Addis Abeba.
  • [4] World Bank (2008).
  • [5] agra-alliance.org/section/work/finance.
  • [6] Fabozzi et al. (2006), p. 1. See also Fender and Mitchell (2005, pp. 69-71) and Fabozzi (2005).
  • [7] For the motives and advantages of securitization as instrument for MFI refinance see for example Glaubitt, et al. (2008), p. 354, or Basu (2005). Risks involved in the securitization process are analyzed in Fender and Mitchell (2005). See also below in this article.
  • [8] Winn et al. (2009), p. 2.
 
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