Agricultural Risks and Risk Management Strategies

Financial institutions are typically reluctant to finance agricultural activities, especially small and medium-sized farmers because of their perceived high costs[1] and risks.[2] In order to discuss whether risks issues of agricultural finance can be tackled with help of SF, we will take a look at risks involved in agricultural finance, as well as at the common approaches of financial institutions to handle these risks.

Classification of Agricultural Risks

Maurer (2013)[3] classifies risks in agricultural lending into three categories: principal credit risks, specific agricultural credit risks and political risks (Figure 3).

Segmentation of Specific Agricultural Risks

Level of risk

Micro

Meso

Macro

Affected groups

Individual farm household

Groups of households or communities

Regions or entire country

Degree of correlation

Idiosyncratic risk (independent)

Covariant risk

Catastrophic or systemic risk

Probability of occurrence

Very frequent

Less frequent

Low frequency

Magnitude of losses

Small losses

Significant losses

Very large losses

Incidence and Examples

Regular variation in production:

x smaller weather shocks, e.g. hail, frost

x non-contagious diseases

x Independent events,

e.g. fire

Large negative production shocks:

x severe weather conditions, e.g. flood

x pest infestation

Highly systemic, shocks affecting a large region and leading to catastrophic losses in production:

x hurricanes, widespread flooding, drought

x epidemic diseases

Risk Layer

Risk retention

Market solutions (Insurance)

Market failure

Risk carrier

Farmers

Private (re-)insurance companies

Government/donors

Risk management strategy

Risk reduction and coping

Risk pooling (insurance) and risk transfer

Risk transfer

Fig. 3. Segmentation of specific agricultural risks. Source: Maurer (2013)

The principal credit risks of agricultural lending (or “normal credit risks”) are quite similar to those of micro and small enterprises, and are related to the high degree of informality of the potential borrowers and the lack of traditional loan collateral. These result in severe information asymmetries (particularly regarding the capacity and the willingness of the borrower to repay loans) and, thus, high screening and monitoring cost for the lender typically combined with relatively small loan sizes due to world-wide predominance of smallholder agriculture.

Specific agricultural credit risks comprise production and price risks. Production risks in agriculture stem from the high variability of production output as a result of external factors like weather (temperature, floods, drought, etc.), pests and diseases. Market price risks are more pronounced in agriculture than in other economic activities due to output price uncertainty and volatility in local as well as international markets. Both risk categories exist at different levels and scale, and are often correlated (see Figure 3). Such covariant risks are more difficult to manage since a diversification of these risks does not help to mitigate them – as it is the case with non-covariant risks. That is why they may hit a significant number of loans of a given loan portfolio at the same time. Hence these portfolios need special agricultural risk management strategies.

Additionally, the agricultural sector in developing countries is more prone to political risk in the form of political interference than other sectors of the economy because of its strategic importance for food security, employment, and poverty reduction. Politically motivated interventions in the form of sudden impositions of interest rate ceilings and the implementation or only the announcing debt relief are still common and constitute a major risk for agricultural lending institutions.[4] Since frequency of occurrence and severity of that type of risk cannot be assessed and predicted, it cannot be transferred and can hardly be managed.[5] In many countries, it may qualify as the type of risk which is considered so high that it prohibits financial institutions from lending to farmers.

  • [1] Some case studies suggest that a distribution reaching out to rural credit customers is not necessarily more costly than in urban areas. See Jainzik and Pospielovsky (2013) in this volume.
  • [2] Actually Meyer (2011) has not found any empirical evidence in the literature which can prove that lending to the agricultural segments is indeed more risky than lending to other sectors. From the authors' experience, it is often misleading to state that banks assess risk of farming businesses and lending to agriculture as high risk. Unfortunately, many banks and other financial institutions have no clear understanding about farm economics and markets for agricultural produce and they are lacking appropriate approaches to analyze the related risks so that there is actually no base for a professional credit risk assessment by the banks. Thus, the reference to high risks in agriculture by banks is often only uninformed perception based on prejudices.
  • [3] Maurer (2013) in this volume; see also OECD (2009).
  • [4] Existing interest rate caps as such (in contrast to their introduction) are not a risk for agricultural lending – interest rate ceilings are “only” preventing lending to smallholders – since costs for doing this lending business cannot be recovered by the banks. As a consequence of interest rate caps, banks steer their credit activities towards medium-sized and large farms. This credit-rationing necessity due to the cap has been found and proven in many studies. Agricultural economist Gonzalez-Vega (1984) has termed it “the Iron Law of Interest-Rate Restrictions”. While interest rate interventions might be well-intentioned and socially motivated or rational from the political point of view, in fact they always lead to negative effects with regard to sustainable financing in the agricultural and rural sector. For a synopsis of the effects of government interventions in agriculture lending see Conning and Udry (2007), pp. 2864 et sqq.
  • [5] See Maurer (2013) in this volume.
 
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