USAID – Workshop on agricultural sector financing

RISKS TO WHICH BANKS ARE EXPOSED IN CONNECTION WITH FINANCING IN THE

AGRICULTURAL SECTORWorkshop on July 22 and 23, 2011

RISKS CONNECTED WITH AGRICULTURE

• Agriculture is an intrinsically risky economic activity

• A broad range of uncontrollable elements may affect the production and the price of products, and result in extremely variable economic returns for farming households

• In developing countries, there is no access to modern risk management instruments, such as agricultural insurance, standardized term contracts or guarantee funds, or to emergency public assistance after the fact

• Farmers apply different adaptation strategies and “traditional risk reduction techniques, most of which are ineffective. Formal and semi-formal agreements such as contractual agriculture and value chain integration have appeared in recent decades, but they remain limited and can be very sensitive to context.

RISKS CONNECTED WITH AGRICULTURE

Formal lenders avoid financing agriculture for many reasons: • High cost of rendering of services

• Asymmetry of information

• Lack of branch networks

• Perceptions of weak profitability in agriculture

• Lack of guarantees

• Extent of rural poverty

RISKS CONNECTED WITH AGRICULTURE

• Low levels of farmers’ financial education and knowledge

• Pronounced lack of control over production and of risk connected with prices with which the sector is confronted

• Misunderstanding of the sector

• Unsuitable risk management tools and methodologies

• Unsuitable credit products• …..

MAJOR RISK CATEGORIES

• Systemic risks

• Financial risks

• Institutional risks

SYSTEMIC RISKS

• Risks connected with production

• Risks connected with prices

• Risks connected with markets

• Risks connected with policies

RISKS CONNECTED WITH PRODUCTION• Climatic conditions

• Seasonality/Production calendars

• Product quality

• Access to inputs and variation of input prices

• Non-diversification of productions

• Insufficient management/Poor quality of production

• Labor problem

• Absence of mechanization

RISKS CONNECTED WITH PRODUCTION (continued)

• Product storage

• Poor harvests/losses

• Fraud

• Illness of the farmer and/or of his family

RISKS CONNECTED WITH PRODUCTION (continued)

...Farmers and agricultural societies habitually rely on seasonal income and must wait a long time for crops to mature, in addition to being exposed to considerable risks. The seasonal character of agricultural activities requires financial services and well-adapted conditions, specifically longer time frames, with amortization deferrals, less frequent repayments,.....

RISKS CONNECTED WITH PRICES

• Strong price sensitivity

• Sectoral trends and correlations

• Market trends

• Asymmetry of information

• The producer undergoes more than he influences/misunderstanding of prices

• Problem of the distribution of added value among the different operators

• ……

RISKS CONNECTED WITH MARKETS

• Weak market organization

• Who are the market players?

• Supply problems

• Marketing problems

• Absence of contract coverage system

RISKS CONNECTED WITH THE MARKET (continued)

…Market inefficiency as a general rule. Value chains are still badly or insufficiently organized, without good price transparency and are fragmented in primary production, resulting in high transaction costs

RISKS CONNECTED WITH POLICIES

• Unwise interventions by public authorities, such as the subsidizing of interest rates and the lack or the non-application of appropriate rules and regulations

• An ineffective legal environment and framework

• Non-application of regulations

• Insufficient rural infrastructure

• Agricultural product supply strategies favoring exports to the detriment of local products

RISKS CONNECTED WITH POLICIES (continued)

...Occasionally, agricultural activity may be considered not as an economic activity but as a social problem with financing in the form of subsidies to farmers and cooperatives, which means that private banks are not on an equal footing

FINANCIAL RISKS

• Risks connected with the borrower

• Risks connected with the capacities of Financial Institutions

• Other bank risks

RISKS CONNECTED WITH THE BORROWER

• Misunderstanding of the sector/Lack of information

• Misunderstanding of the characteristics of different productions-channels-markets/Lack of information

• Misunderstanding of processes, of the value chain

• “Language” difference/”cultural” difference

• Problem of geographic access

• Legal risks connected with non-registration, with land title...

RISKS CONNECTED WITH THE CAPACITIES OF FINANCIAL INSTITUTIONS

• Unsuitable products

• Unsuitable risk management methodology

• Inadequate distribution circuit (branch network/points of sale)

• Absence of clear segmentation for optimal management of sector financing

• Importance given to the 2nd way out

• High operating costs

OTHER BANK RISKS

• Risk of non-repayment of credit

• Risk of late repayment of credit

• Problem of fulfillment of the guarantee

• Operational risk: defective safety and control system, defective procedures...

• Reputation risk

• Market risk (interest rate, exchange rate)

INSTITUTIONAL RISKS

• Inadequate infrastructure (poor condition of roads, irregular supply of electricity and lack of communication systems) which prevent agricultural goods from moving and from actually reaching customers

• Generalized dispersal of the population in rural areas which causes transaction and information costs to increase, and thus also hinders the expansion of financial services

• Questionable legal environment with uncertainty about titles of ownership (specifically property in rural areas) limits bank guarantee options because accurate land registration and applicable mortgage systems are important issues for rural development

INSTITUTIONAL RISKS (continued)

• A large number of farmers only recently passed from subsistence farming to commercial farming and their contacts with the real monetary economy and their experience in managing cash flow remain limited

• An ineffective legal environment and framework

• Non-application of regulations

• Little financial knowledge particularly among small farmers and limited understanding of banking requirements. Small farmers’ low level of education

CONCLUSION

Financial Institutions must not avoid risk, nor deny it, but rather, know how to manage it