RESEARCH REPORT ON

RISK MANAGEMENT IN AGRICULTURAL FINANCE

SHAFQAT ULLAH

INSTITUTE OF MANAGEMENT SCIENCES

PESHAWAR PAKISTAN

May 2007

RESEARCH REPORT ON

RISK MANAGEMENT IN AGRICULTURAL FINANCE

Research report submitted to the Institute of Management Sciences

Peshawar in partial fulfilment of the requirements for the degree of

Master in Business Administration

May 2007

INSTITUTE OF MANAGEMENT SCIENCES

PESHAWAR

RESEARCH REPORT ON

RISK MANAGEMENT IN AGRICUTURAL FINANCE

Supervisor:

Signature ______________________ Name Mr. Muhammad Rafiq Designation Coordinator BBA

Coordinator Research & Development Division:

Signature ____________________ Name Mr. Owais Mufti

PREFACE

Research report is the last step in completion of the MBA degree. This is an

excellent and interesting part of the course because a lot is learnt during the

research writing. This helps students in analysing different problems not only for

the course requirement but also for future career.

The present research is about different risks associated with agricultural finance

and its effective management by agricultural credit institution and agricultural

credit department of commercial banks.

The reason for selecting agricultural finance sector for the research is that 50% of

the workforce of the country are involved agriculture and agricultural finance is

one of most important and inseparable part of agricultural business. Risk is a

necessary part of agricultural finance because agriculture is a risky business and

the risk is transferred to agricultural lending institution since they are connected

with agriculture business. Banks surely need an effective risk management policy

to cope with the risks involved in agricultural finance.

Such a research will not only help institutions lending for agricultural purposes

but also people connected with agriculture, livestock etc businesses. And sure

this research report will play its role in this respect.

Shafqat Ullah

MBA (Banking & Finance)

TABLE OF CONTENTS

Topic Page #

Preface i

Table of Contents i i

Lis t of Graphs iv

Execut ive Summary v

SECTION ONE: INTRODUCTION 1-4

Chapter 1

1.1 Background 1

1 .2 Risk 2

1 .3 Risk Management 2

1 .4 Object ives of the Study 3

1 .5 Scope of the Work 3

1 .6 Scheme of the Report 3

SECTION TWO: REVIEW OF LITERATURE 11-30

Chapter 2: Review of Literature 11-23

Chapter 3: Risk and Risk Management 24-30

3.1 Risk 24

3.1.1 Systemat ic Risk 25

3.1.2 Non-systemat ic Risk 25

3.2 Risk Management 25

3.3 Risk Management Process 26

3.3.1 Risk Ident i f icat ion 27

3.3.2 Risk Assessment 27

3.4 Potent ial Risk Treatments 28

3.4.1 Risk El imination 28

3.4.2 Risk Mit igat ion 29

3.4.3 Risk Retent ion 29

3.4.4 Risk Transfer 30

3.5 Limitat ions 30

SECTION THREE: ANALYSIS 31-34

Chapter 4: Analysis

4.1 Cause-and-Effect Analysis 31

4.2 Causes of Liquidi ty Risk 32

4.3 Causes of Operat ional Risk 33

4.4 Causes of Market Risk 33

4.5 Causes of Weather Risk 34

4.6 Their Effect 34

4.7 Agricul ture Credi t Del ivery 35

SECTION FOUR: RECOMMENDATIONS 37-38

CONCLUSION 39-40

REFERENCES 41-43

LIST OF GRAPHS

Number Figure Tit le Page Figure 3.1 Risk Treatment 28

Figure 4.1 Fishbone Diagram 32

Figure 4.2 Effects on Profi tabi l i ty 34

Figure 4.3 Credi t Requirement & Disbursement 35

EXECUTIVE SUMMARY

The present research study has been conducted to identify different types of risks

associated with agricultural finance, their possible effects of profitability of

agricultural lending institution and risk management strategies that have been

designed to cope with these risks.

Agriculture businesses have great exposure to risk and this risk not only affects

the farmer but also the institution lending to farmer for agricultural purpose. Risk

has serious consequences for income generation and for loan repayment capacity

of borrower. Agricultural insurance is a useful tool to manage the risks but it has

limited role in agriculture sector of Pakistan especially small farmers have almost

no access. Problems associated with inadequate loan collateral pose specific

problems to agricultural lenders. Lenders consider movable assets, such as

livestock as higher risky forms of security. Market and price risks are due to

market fluctuations in prices particularly where information is lacking and where

markets are imperfect. The relatively longer time period between cultivation and

harvesting means that market prices are unknown at the moment when a loan is

granted. Free trade and exposure to foreign markets increases price risk for

farmers. Countries with smaller markets experience more volatility than markets

with large volume trade. The dispersed farmer-borrowers with small loan volumes

lead to high financial transaction costs both for borrower and institution and

increase perception of high risk. Mismatching the term of loan assets and

liabilities exposes a financial institution to high liquidity risks. The liquidity

position of agricultural lenders is affected by agricultural seasonality. To protect

themselves, banks should carefully match maturity of their loans with that of their

loanable resources.

Risk is defined by the adverse impact on profitability of several distinct sources of

uncertainty. While the types and degree of risk of an organisation or system may

be exposed to depend upon a number of factors such as size, complexity, business

activities, volume etc. Risk management is the process of measuring or assessing

risk and developing strategies to manage it. Strategies may include transferring of

the risk, avoiding the risk, reducing the negative effects of the risk and accepting

some of the consequences of the risk. Traditional risk management covers actions

taken both before and after the risky events occur.

By analysing these risk by fishbone diagram which is developed by Dr. Ishikawa,

it is clear that there are four major categories that affects the banks’ profitability.

Weather risk, liquidity risk, operational risk and market risk collectively have

mostly negative effects on banks’ profitability and therefore often institutions

hesitate in forwarding loan to this sector and eventually the credit demand is not

covered by the supply of credit.

To effectively manage these risks financial institutions need to classify the loan in

terms of risk and should first start lending in low risk zone and then gradually to

high risk zone. The credit risk should be minimised by appropriate collateral and

information database of borrowers’ creditworthiness. The repayment schedule

should be designed as such that is convenient for borrower to repay the loan on

time with interest. Market risk can be minimised by diversifying income

generation sources for rural household. The institution has to design effective risk

management policy and consistently follow it.

CHAPTER: 1

INTRODUCTION

1.1 BACKGROUND:

Agriculture is of vital importance in Pakistan’s economy. It accounts for about

22% to the GDP and about 66% to export earnings. Not only 44.8% of the

workforce are engaged in agriculture but also 65.9% of the country’s population

is living in rural areas, which is directly or indirectly related to agriculture for

their livelihood. Any effect on agricultural performance would affect the large

number of population and of course the growth of the country’s economy as well.

The performance of agriculture has been weak during the fiscal year 2005-06.

Overall agriculture grew 2.5% against the target of 4.2% which is very low as

compared to 6.7% which is the achievement of year 2004-05.

Farmers need seeds, fertilisers, pesticides, agricultural machinery, labour and

farm houses etc and for this they demand funds if they are in short of money for

operation of these activities. This demand is fulfilled by financial institutions,

banks, and co-operatives, NGOs and or by their relatives, friends. But the main

supplier of credit to farmers is financial institutions, co-operatives etc.

In Pakistan there are some specialised agricultural finance institutions such as

ZTBL. Other than these the agricultural credit departments of commercial banks

are also engaged in lending for agricultural purposes. A total of Rs. 111195.168

million was disbursed as loan by all financial institutions for agricultural purposes

during the period of July 05 to Mar07; Rs.91160.959 million was disbursed

during corresponding period last year.

Although there is an increase in agricultural credit disbursement but still the credit

supply is not consistently increasing as the demand is increasing. The reason is

that there many risks involved in agriculture and therefore institutions hesitate to

advance loan for agricultural purposes. The present research is related to same

topic that how different risks involved in agricultural finance affect the

profitability of a bank and how it can be managed effectively.

1.2 RISK:

“The possibility that the outcome of an action or event could bring up adverse

impacts. Such outcomes could either result in a direct loss of earnings / capital or

may result in imposition of constraints on bank’s ability to meet its business

objectives.”1

1.3 RISK MANAGEMENT:

Risk management is a very critical issue in many sectors as well as in agricultural

finance. Agricultural finance needs even more and better risk management

strategies because agriculture is comparatively more risky business.

“Risk management is the process of identifying, measuring or assessing risk and

developing strategies to manage it.”2

1.4 OBJECTIVES OF THE STUDY:

The main objectives of the study are to

1 Find out different risks involved in agricultural finance faced by financial

institutions, co-operative societies, NGOs etc

2 Determine the effects of these risks on the profitability of agricultural

lending institutions.

3 Analyse the risk management strategies that are used to cope with these risks

4 And to suggest recommendations to manage these risk effectively

1 Definition by State Bank of Pakistan 2 Definition by Wikipedia Encyclopaedia

1.5 SCOPE OF THE WORK:

Agricultural finance is faced with many challenges because agriculture is a very

risky business and this risk is then transferred to agricultural lending institutions

because they are connected to it. Since there are many challenges faced by

agricultural finance therefore it is not possible to cover all of them in this research

report.

Therefore this research is limited to the risk management challenge in agricultural

finance. It will cover different risks that financial institutions are facing with in

lending to farmers for agricultural purposes.

Weather risk will be covered in the research that is the main risk in agriculture.

Other than this liquidity risk, credit risk, operational risk etc will be covered in

this research report.

1.6 SCHEME OF THE REPORT:

The first section of the report is the introduction section, in which background of

the topic is discussed. Risk and risk management is defined, objectives and scope

of the research report is described.

In the second section the viewpoints and findings of different researchers on

similar topics have been discussed and comprehensively define risks, its different

types, risk management and risk management process.

In the third section the problems are analysed by using fishbone diagram and

using some data to analyse agricultural finance challenges.

The fifth section of the report is about recommendations. And at the end the

report has conclusion and references.

CHAPTER: 2

REVIEW OF LITERATURE

Agriculture remains a dominant activity in many rural economies of the poorest

nations in the world. A large majority of the poorest households in the world are

directly linked to agriculture in some fashion. Risks in agriculture are most

certainly not independent in nature. When one household suffers bad fortune it is

likely that many are suffering. These common risks are referred to as correlated

risk. When agricultural commodity prices decline everyone faces a lower price.

When there is a natural disaster that destroys either crops or livestock, many

suffer. Insurance markets are sorely lacking in most developing and emerging

economies, and rarely do local insurance markets emerge to address correlated

risk problems. (Skees, Jerry 2003)

Agricultural risk is associated with negative outcomes that stem from imperfectly

predictable biological, climatic, and price variables. These variables include

natural adversities (for example, pests and diseases) and climatic factors not

within the control of agricultural producers. They also include adverse changes in

both input and output prices. To set the stage for the discussion on how to deal

with risk in agriculture, we classify the different sources of risk that affect

agriculture.

Agriculture is often characterised by high variability of production outcomes or,

production risk. Unlike most other entrepreneurs, agricultural producers are not

able to predict with certainty the amount of output that the production process will

yield due to external factors such as weather, pests, and diseases. Agricultural

producers can also be hindered by adverse events during harvesting or collecting

that may result in production losses. (World Bank Report 2005)

Risks impact borrowing farmers and the financial institutions that lend to them.

Active management can reduce these risks. Risks and uncertainty are pervasive in

agricultural production and are perceived to be more serious than in most non-

farm activities. Production losses are also impossible to predict. They can have

serious consequences for income-generation and for the loan repayment capacity

of the borrowing farmer. The type and the severity of risks which farmers face

vary with the type of farming system, the physical and economic conditions, the

prevailing policies, etc. (Klein, B., Meyer, R., Hannig, A., Fiebig, M 1999)

Risks can be of different natures and include those associated with the impact of

unfavourable weather on production, (drought, hail, floods), diseases or pest

damage, economic risks due to uncertain markets and prices, productivity and

management risks related to the adoption of new technologies, and credit risks as

they depend on the utilisation of financial resources and the repayment behaviour

of farmer clients. The relative importance of these different risks will vary by

region and by type of farmer. For example, marketing risks are greater for mono-

crop cultures in developing countries, which depend on volatile world markets.

These risks will also decrease as the level of education of farmers and the

availability of information on markets, prices and loan repayment behaviour

increase. In some cases, especially for relatively high technology farming that

involves significant investments, agricultural insurance may be useful as a risk

management tool. But it should be used only for specific crop/livestock

enterprises and for clearly defined risks (Roberts and Dick, 1991; Roberts, R.A.J

and Hannig, A 1998)

Agriculture is inherently dependent on the vagaries of weather, such as the

variation in rainfall. This leads to production (or yield) risk, and affects the

farmers’ ability to repay debt, to meet land rents and to cover essential living

costs for their families. But the effects of weather events also matter for rural

lending institutions and agri-businesses, as they determine the risk exposure of

borrowers and input providers. With weather conditions affecting a large share of

business activity, many developing countries in Sub-Saharan Africa and other

parts of the world display a high sensitivity of both agricultural and GDP to

fluctuations in rainfall (Benson and Clay, 1998 and Guillaumont, Guillaumont,

Jeanneney and Brun, 1999). Ultimately, the precariousness of farmers and

producers translates into macroeconomic vulnerability.

Developing countries are not just more dependent on weather conditions but also

suffer the brunt of natural disasters (due to the hazardous environmental

conditions), many of which are caused by weather hazards. According to World

Bank (2001), between 1988 and 1997 natural disasters claimed an estimated

50,000 lives a year and caused direct damage valued at more than US$60 billion a

year. Developing countries incurred the vast majority of these costs: 94% of the

world’s 568 major disasters between 1990 and 1998 took place in developing

countries. In Asia, which experiences 70% of the world’s floods, the average

annual cost of floods over the 1990s was estimated at US$15 billion. On the basis

of current trends, these numbers are likely to rise in the future. (Freeman, 1999).

Farmers in developing countries have always been exposed to weather risks, and

for a long time have developed ways of reducing, mitigating and coping with

these risks (Dercon, 2002). Traditional risk management covers actions taken both

before (ex-ante) and after (ex-post) the risky event occurs (Siegel and Alwang,

1999). Examples of ex-ante strategies include the accumulation of buffer stocks as

precautionary savings and the diversification of income-generating activities

through changing labour allocation (working in farm and non-farm small

businesses, and seasonal migration) or varying cropping practices (planting

different crops, like drought-resistant variants, planting in different fields and

staggered over time, intercropping, and relying on low risk inputs). Similarly,

companies may self-insure through high capitalisation and diversification of

business activities. Communities collectively mitigate weather risks with

irrigation projects and conservation tillage that protects soil and moisture.

Examples for ex-post strategies range from farmers seeking off-farm employment,

to distress sales of livestock and other farm assets, to withdrawal of children from

school for farm labour, and to borrowing funds from family, friends and

neighbours (Hanan and Skoufias, 1998).

When a hurricane or an earthquake occurs not everyone has a total loss. Still,

many losses do occur at the same time. Crop losses have similar characteristics.

While events such as too little rain, too much rain, or widespread frost create

widespread crop losses, not every farm experiences the same loss. The challenge

for those insuring losses from hurricanes, earthquakes, and crop disasters is to

have access to enough capital to cover worst-case scenarios. Since catastrophic

risks are not independent, and in the classic sense are uninsurable, special global

markets have emerged to share these risks. The traditional mechanism is to share

catastrophic risk with another insurance entity by what is called reinsurance.

Reinsurance can take many forms. The simplest form to consider is another

insurance policy on the insurance losses for a local insurance provider. Such a

policy can be arranged as a ”stop loss” policy: The local insurance provider pays a

premium to the global re-insurer who agrees to pay for all losses beyond a certain

threshold. As long as the re-insurer mixes this into a global book of business, then

what were correlated risks at the local level become independent risks at the

global level. (Skees, Jerry 2003)

Management of yield or price risk through the purchase of crop insurance

transfers risk from you to others for a price which is stated as an insurance

premium. Crop insurance is an example of a risk management tool that not only

protects against losses but also offers the opportunity for more consistent gains.

When used with a sound marketing program, crop insurance can stabilise

revenues and potentially increase average annual profits.

Crop insurance provides two important benefits. It ensures a reliable level of cash

flow and allows more flexibility in your marketing plans. If you can insure some

part of your expected production, that level of production can be forward-priced

with greater certainty, creating a more predictable level of revenue. With the

elimination of ad hoc disaster payments and deficiency payments, crop producers

will no longer receive government aid during years of crop disasters or price

support payments during low price years. Crop insurance provides partial

replacement for the Federal safety net. (Kaan, Dennis)

Insurance is another formal mechanism used in many countries to share

production risks. However, insurance is not as efficient in managing production

risk as derivative markets are for price risks. Price risk is highly spatially

correlated and, as illustrated by Figure 2.1, futures and options are appropriate

instruments to deal with spatially correlated risks. In contrast, insurance is an

appropriate risk management solution for independent risks. Agricultural

production risks typically lack sufficient spatial correlation to be effectively

hedged using only exchange-traded futures or options instruments. At the same

time, agricultural production risks are generally not perfectly spatially

independent and therefore insurance markets do not work at their best. Skees and

Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et

al. (1982), “good or bad weather may have similar effects on all farmers in

adjoining areas” and, consequently, “the law of large numbers, on which premium

and indemnity calculations are based, breaks down.” In fact, positive spatial

correlation in losses limits the risk reduction that can be obtained by pooling risks

from different geographical areas. This increases the variance in indemnities paid

by insurers. In general, the more the losses are positively correlated, the less

efficient traditional insurance is as a risk-transfer mechanism. For many ideas

presented in this document, a precondition for success is a high degree of positive

correlation of losses.

Agricultural insurance has a limited role in farming, in particular for small

farmers. Its applicability in any given situation is defined by the test as to whether

it is the most cost-effective means of addressing a given risk. When it has a role

the resulting action should be attached to existing insurance operations in order to

take advantage of existing insurance expertise, record keeping and accounting

systems and equipment. On the other hand, agricultural insurance operations

require some special skills. This approach can partly be provided through

manuals, but personal observation through study tours of efficient crop insurance

programs can also be useful.

Mechanism used in many countries to share production risks. However, insurance

is not as efficient in managing production risk as derivative markets are for price

risks. Price risk is highly spatially correlated and futures and options are

appropriate instruments to deal with spatially correlated risks. In contrast,

insurance is an appropriate risk management solution for independent risks.

Agricultural production risks typically lack sufficient spatial correlation to be

effectively hedged using only exchange-traded futures or options instruments. At

the same time, agricultural production risks are generally not perfectly spatially

independent and therefore insurance markets do not work at their best. Skees and

Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et

al. (1982), “good or bad weather may have similar effects on all farmers in

adjoining areas” and, consequently, “the law of large numbers, on which premium

and indemnity calculations are based, breaks down.” In fact, positive spatial

correlation in losses limits the risk reduction that can be obtained by pooling risks

from different geographical areas. This increases the variance in indemnities paid

by insurers. In general, the more the losses are positively correlated, the less

efficient traditional insurance is as a risk-transfer mechanism.

The lack of statistical independence is not the only problem with insurance in

agriculture. Another set of problems is related to asymmetric information — a

situation that exists when the insured has more knowledge about his/her own risk

profile than does the insurer. Asymmetric information causes two problems:

adverse selection and moral hazard. In the case of adverse selection, farmers have

better knowledge than the insurer about the probability distribution of losses.

Thus, the farmers have the privileged situation of being able to discern whether or

not the insurance premium accurately reflects the risk they face. Consequently,

only farmers that bear greater risks will purchase the coverage, generating an

imbalance between indemnities paid and premiums collected. Moral hazard is

another problem that lies within the incentive structure of the relationship

between the insurer and the insured. After entering the contract, the farmer’s

incentives to take proper care of the crop diminish, while the insurer has limited

effective means to monitor the eventual hazardous behaviour of the farmer. This

might also result in greater losses for the insurer.

Since both price and yield risk for agricultural commodities are spatially

correlated, rural finance markets are often limited in their ability to help

individuals either smooth consumption or manage the business risk associated

with producing crops and livestock. For that matter, any form of collective or

group action assisting individuals to manage correlated risk at the local level is

doomed. (Skees, Jerry 2003)

Yield uncertainty due to natural hazards refers to the unpredictable impact of

weather, pests and diseases, and calamities on farm production (Ellis, 1988).

Risks severely impact younger, less well-established, but more ambitious farmers.

Especially affected are those who embark on farming activities that may generate

a high potential income at the price of concentrated risks - e.g. in the case of high

input mono-culture of maize. Subsequent loan defaults may adversely affect the

creditworthiness of farmer borrowers and their ability to secure future loans.

(Klein, B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

A conventional bank practice that protects the lender against possible borrower

default is the requirement of loan collateral such as real estate or chattel mortgage.

Banks use loan collateral in order to screen potential clients (as a substitute for

lack of customer information) and to enforce and foreclose loan contracts in the

event of loan default. The preferred form of conventional bank collateral is

mortgage on real property, which, however, requires clear land titles and

mortgage registration. In general, real estate and land are considered to be “low

risk”, while chattel mortgages of movable assets such as machinery and animals

incur a greater risk, unless these items can be clearly identified, and are properly

insured against theft, fire and loss. In the absence of conventional types of

collateral such as land, livestock and machinery, other forms of supplementary

collateral are sometimes accepted by banks, such as third party guarantees,

warehouse receipts and blocked savings. Without secure loan collateral, it is

expected that there will be a contraction in the supply of bank credit and this will

result in reduced access of small farmer and rural clients to finance.

In the informal credit market, where intimate client knowledge and, often, inter-

linked trade/credit arrangements exist, non-tradable assets or collateral substitutes,

such as reputation and credit worthiness, are much more prominent. Group

lending based on group control and joint and several liability of group members,

and group savings are suitable forms of collateral substitutes. These are

increasingly used by donors and NGOs. It may be effective if groups are

homogenous in their composition, interests and objectives and when problems of

moral hazard can be avoided. However, in many countries, groups of farmers do

not easily meet these criteria. In addition, also due to the long duration of

agricultural loans and high costs of group training, individual lending in

agricultural finance, in general, is much more widespread and might be more

appropriate than group lending. Moreover, successful experience with group

lending is chiefly for non-agricultural purposes. (Binswanger and McIntire, 1987)

Problems associated with inadequate loan collateral pose specific problems to

rural lenders. Land is the most widely accepted asset for use as collateral, because

it is fixed and not easily destroyed. It is also often prized by owners above its

market value and it has a high scarcity value in densely populated areas.

Smallholder farmers with land that has limited value, or those who have only

usufruct rights, are less likely to have access to bank loans. Moveable assets, such

as livestock and equipment, are regarded by lenders as higher risk forms of

security. The owner must provide proof of purchase and have insurance coverage

on these items. This is rarely the case for low-income farm households.

Moreover, there are a number of loan contract enforcement problems, even when

borrowers are able to meet the loan collateral requirements. Restrictions on the

transfer of land received through land reform programmes limits its value as

collateral - even where sound entitlement exists. In many developing countries the

poor and especially women have most difficulties in clearly demonstrating their

legal ownership of assets. Innovative approaches which draw on the practices of

informal lenders and provide incentives to low income borrowers to pay back

their loans have been developed in micro-credit programmes.

Credit risk arises with all over-the-counter contracts as both parties have promised

to pay the other in the future, depending on the final value of an index, and must

be trusted to live up to the promise. This can be contrasted with exchange-traded

securities where the exchange assures final payment. Credit risk or the risk of

default of the counterpart in emerging markets is compounded by currency

transfer risk. In other words it does not matter to the weather risk provider

whether the default is triggered by a macro problem (the Peso crisis, for example)

or counterpart default the risk rating will be equal or lower to the country risk

rating.

Risks are also related to the duration of loans, since the uncertainty of farm

incomes and the probability of losses increases over longer time horizons. Thus,

given the average short maturity of loan-able resources in deposit-taking financial

institutions, and considering the time horizon of agricultural seasonal and

investment loans, commercial bankers are normally reluctant to engage

themselves in agricultural lending. To protect themselves, banks should carefully

match the maturity of their loans with that of their loan-able resources and apply

measures to protect their loan portfolio from potential risk losses.

Input and output price volatility are important sources of market risk in

agriculture. Prices of agricultural commodities are extremely volatile. Output

price variability originates from both endogenous and exogenous market shocks.

Segmented agricultural markets will be influenced mainly by local supply and

demand conditions, while more globally integrated markets will be significantly

affected by international production dynamics. In local markets, price risk is

sometimes mitigated by the “natural hedge” effect in which an increase (decrease)

in annual production tends to decrease (increase) output price (though not

necessarily farmers’ revenues). In integrated markets, a reduction in prices is

generally not correlated with local supply conditions and therefore price shocks

may affect producers in a more significant way. Another kind of market risk

arises in the process of delivering production to the marketplace. The inability to

deliver perishable products to the right market at the right time can impair the

efforts of producers. The lack of infrastructure and well-developed markets make

this a significant source of risk in many developing countries. (World Bank

Report 2005)

Price uncertainty due to market fluctuations is particularly severe where

information is lacking and where markets are imperfect, features that are

prevalent in the agricultural sector in many developing countries (Ellis, 1988).

The relatively long time period between the decision to plant a crop or to start a

livestock enterprise and the realisation of farm output means that market prices

are unknown at the moment when a loan is granted. This problem is even more

acute for perennial tree crops like cocoa and coffee because of the gap of several

years between planting and the first harvest. These economic risks have been

particularly noticeable in those countries where the former single crop buyer was

a parastatal body. These organisations announced a buying price before planting

time. Many disappeared following structural adjustment reforms and privatisation

of agricultural support services. Private buyers rarely fix a blanket-buying price

prior to the harvest, even though various inter-linked transactions for specific

crops have become more common today. These arrangements almost always

involve the setting of a price or a range of prices, prior to crop planting. (Klein,

B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

One way producers have traditionally managed price variability is by entering

into pre-harvest agreements that set a specific price for future delivery. These

arrangements are known as forward contracts and allow producers to lock in a

certain price, thus reducing risk, but also foregoing the possibility of benefiting

from positive price deviations. In specific markets, and for specific products,

these kinds of arrangements have evolved into futures contracts, traded on

regulated exchanges on the basis of specific trading rules and for specific

standardised products. This reduces some of the risks associated with forward

contracting (for example, default). A further evolution in hedging opportunities

for agricultural producers has been the development of price options that

represent a price guarantee that allows producers to benefit from a floor price but

also from the possibility of taking advantage of positive price changes. With price

options, agents pay a premium to purchase a contract that gives them the right

(but not the obligation) to sell futures contracts at a specified price. Price options

for commodities are regularly traded on exchanges but can also be traded in over-

the-counter markets. Futures and options contacts can be effective price risk

management tools. They are also important price discovery devices and market

trend indicators.

For agricultural producers in developing countries, access to futures and options

contracts is probably the exception rather than the rule. However, futures and

options markets in developed countries represent important price discovery

references for international commodity markets and indirect access to these

exchange-traded instruments may be granted through the intermediation of

collective action by producer groups such as farmer cooperatives or national

authorities.8 While futures and options are an important reality for some

commodities, they are not available for all agricultural products. (World Bank

Report 2005)

Freer trade and exposure to world markets increases price risks for farmers,

especially in countries that are price takers in international markets. This will vary

between commodities. For example, relatively small world markets with few

exporting countries (rice) may experience more price volatility than markets

which trade a fairly large portion of the domestic crop production of a larger

number of producing countries (wheat). Moreover only the largest farmers have

access to risk management instruments such as options. (Roberts, R.A.J and

Hannig, A 1998)

When risks are nearly 100 percent correlated, futures exchange markets have

emerged to allow many buyers and sellers of the risk to share risk in an organised

fashion. These markets have allowed participants to protect common or correlated

risks such as changing commodity prices, interest rates, and exchange rates.

Futures markets have a much longer history of successful use than many of the

ideas presented in this paper. Thus, less time will be spent explaining these

markets. Despite well-functioning futures markets, because of the complexity of

and the size needed to participate in futures markets, intermediaries are needed to

facilitate participation in something that looks much more like direct price

insurance. The World Bank has been working with investment banks and with the

International Finance Corporation (IFC) to offer something that is much more

akin to price insurance or an Asian put option. If the domestic price is highly

correlated with a futures market price, it is possible to offer such contracts to local

users in a developing country. The buyer (such as a RFE) would pay a premium

for the right to obtain price protection at some level. For example, if the world

price of coffee is trading at 40 cents, the RFE could purchase an option or

insurance that would pay anytime the world price of coffee drops below 30 cents.

The payment would be made in such a fashion as to make up the difference

between the new lower world price and the 30-cent level. By packing various size

contracts, the investment bankers and IFC hope to make these types of contracts

more accessible to a wide array of users. Kenyan coffee is used in this paper as a

case that may fit the necessary condition that domestic price be highly correlated

with an internationally traded exchange market.

Mismatching the term of loan assets and liabilities exposes a financial institution

to high liquidity risks. Good liquidity management requires priority attention in

agricultural lending. The liquidity position of agricultural lenders is affected, in

particular, by agricultural seasonality. Careful liquidity management is also

needed in the event of large changes in agricultural commodity prices, or natural

disasters. Under these circumstances withdrawals of rural savings and new loan

demand of farmers occur at the same time. Agricultural lenders need reliable

information on the timing of required loan disbursements and scheduled loan

repayments to properly plan and manage their cash requirements. Sufficient funds

should be available at the beginning of the planting season, while the high costs of

keeping loan-able funds idle should be minimised as much as possible.

Ensuring liquidity and adequate cash flow is the same as ensuring the farm's

ability to survive shortfalls in net income relative to various cash obligations.

Assets classified as current on the balance sheet are assets that can be converted

into cash within one operating cycle of the farm business, usually 12 months.

Liquid assets include instruments that yield cash directly or that can be converted

quickly to cash. Liquid assets include cash on hand, supplies, and crops and

livestock to be sold within the year.

Adequate liquidity is essential to ensure a sufficient cash flow. Also, adequate

liquid reserves can facilitate contingency plans for production disasters or poor

market conditions. However, excess liquidity typically generates lower rates of

return than fixed assets.

Timing is critical for ensuring adequate cash flows. With proper planning of

expenses, cash flow needs can be known with reasonable certainty. This allows

you to plan marketing decisions in advance and to take advantage of attractive

pricing opportunities. Improving liquidity to ensure adequate cash flows can

include reducing family living expenditures, using resources efficiently, leasing

assets, and utilising appropriate insurance programs.

Agricultural lending implies high liquidity risks due to the seasonality of farm

household income. Surpluses supply increased savings capacity and reduced

demand for loans after harvest and deficits reduce savings capacity and increase

demand for loans before planting a crop. Also, agricultural lenders face particular

challenges when many or all of their borrowers are affected by external factors at

the same time. This condition is referred to as covariant risk which can seriously

undermine the quality of the agricultural loan portfolio. As a result, the provision

of viable, sustainable financial services and the development of a strong rural

financial system is contingent on the ability of financial institutions to assess,

quantify and appropriately manage various types of risk

Most small farmers and other rural entrepreneurs, due to their dispersed location

and the general poor rural infrastructure, experience great difficulty in accessing

urban-based banks. Rural client dispersion and small loan volumes lead to high

financial transaction costs both for banks and borrowers, and increase the

perception of high risks which banks usually associate with small rural clients. In

addition, current bank practices and procedures may discourage rural clients from

using formal financial services and, in many cases, rural people are even unaware

of the availability of financial services or of the conditions under which these are

available. Moreover, small farmers have to make many visits to banks at office

hours which may not be convenient to them, while banks lack essential

information on the credit history of potential clients, the viability of on-farm

investments, the self-financing capacity of farmers and their repayment capability.

Transaction costs in rural areas are high compared to urban areas, due to problems

of collateral provision, low and irregular income flows and the small amounts

involved in the transactions. Three types of borrower have been identified

transaction costs: non-interest charges by lenders; loan application procedures that

require the applicant to deal with agents outside the banking system, such as

agricultural extension staff, local officials and co-signers; and travel expenses and

time spent promoting and following up the application (Von Pischke, 1991). Due

to these factors the costs of reaching the rural poor and small-scale farmers are

high for financial institutions, which charge high interest rates when compared to

market rates in the formal banking sector. The overall costs of formal borrowing

therefore, in many cases, may result in borrowing from the informal sector

becoming more attractive to small-scale farmers. The challenge still remains to

design and expand the provision of loan products to better service the farming

community and to lower transaction costs to improve the terms and conditions of

lending for agriculture. This will demand improved management of existing rural

financial intermediaries, and innovations or ‘new methods’ in financial

intermediation for the agricultural sector.

Banks may decide to open rural branches, but the demand for bank services needs

to be large enough to warrant setting up such a rural branch network. Efforts to

expand the range of financial services by including savings mobilisation and

current accounts may lead to economies of scale and thus to higher efficiency.

Simplification of loan procedures may minimise the travel time and costs for

individual borrowers, while group lending based on joint and several liability of

group members and liaison with NGOs are other means of reducing costs. In all

cases, the availability of decentralised financial intermediation services is a

precondition for effective on-farm lending. (Roberts, R.A.J and Hannig, A 1998)

Low population density coupled with dispersed location of rural clients make the

provision of formal financial services costly. From the lender’s perspective, the

long distances between communities and the inadequate rural transportation

facilities in many developing countries increase the costs of loan appraisal, loan

monitoring and enforcement of loan repayments (Gurgand, et al. 1996). The use

of mobile loan officers and/or branch offices can be effective in lowering

transaction costs. But mobile facilities may be subject to security risks if bank

staff is required to transport money. The establishment of a rural branch network

reduces the security risks, but branches are costly to maintain and to supervise.

Financial transaction costs of institutional credit can also be high for rural

borrowers. This results from the high opportunity costs of lost working time. A

borrower may have to pay several visits to the bank branch office to conclude

cumbersome loan application procedures which require a long time for

processing. Clients often have to spend much time and money to obtain the

required documents and to find loan guarantors. For very small loans, these costs

can significantly increase the effective lending interest rate (Klein, 1996). While

the decentralisation of field operations has been effective in reducing the

transaction costs in some countries their success depends on the local

environment, infrastructure conditions and the management skills of the financial

institution.

Potentially serious risk problems have raised from the effects of failed directed

credit programmes. The impact on the loan repayment discipline is pervasive.

Borrowers who have witnessed the emergence and demise of lending institutions,

have been discouraged from repaying their loans. Further people have repeatedly

received government funds under the guise of “loans”. Loan clients have been

conditioned to expect concessional terms for institutional credit. Under these

circumstances, the incidence of moral hazard is high. The local “credit culture” is

distorted among farmers and lenders. Borrowers lack the discipline to meet their

loan repayment obligations, because loan repayment commitments were not

enforced in the past. Lenders, on the other hand, lack the systems, experience and

incentives to enforce loan repayment. There is also an urgent need to change bank

staff attitudes and the poor public image of financial institutions in rural areas.

Another effect of a distorted credit culture on the risk exposure of agricultural

lenders is the priority that borrowers give to repaying strictly enforced informal

loans. These are settled before they comply with the obligations associated with

“concessional” institutional credit. This is explained by the fact that losing the

access to informal credit is viewed as more disadvantageous than foregoing future

bank loans (due to the uncertain future of rural financial institutions). Very often

informal lenders have stronger enforcement means than banks.

Farmers always know more about their yield potential and risk than anyone from

the outside (either the government or a private insurer). Such asymmetry in

information creates the dual problems of adverse selection and moral hazard.

Adverse selection occurs when there are problems in classifying risk of potential

purchasers. Because farmers know the most about their potential yields, they will

look at the insurance offer and decide if it is fair or maybe even more than fair.

Those who conclude that it is more than fair will buy. Those who conclude it is

overpriced for their risks will stay out. (Seeks, R. J. 2003)

Policy changes and state interventions can have a damaging impact on both

borrowers and lenders. For the latter they can contribute significantly to covariant

risks. Many low-income economies under structural adjustment programmes

have slashed their farming subsidies. This has had, for instance, a serious effect

on the costs and the demand for fertiliser. Reducing government expenditures as

an essential part of structural adjustment programmes may also affect

employment opportunities in the public sector. Costs may even reduce

agricultural production levels, if extension services are suddenly discontinued.

Policy makers should also carefully consider the structural characteristics of

agriculture for different countries. In general, farms in developing countries are

significantly smaller than farms in countries like the United States and Canada.

For traditional crop insurance products, smaller farms typically imply higher

administrative costs as a percentage of total premiums. A portion of these costs

are related to marketing and servicing (loss adjustment) insurance policies.

Another portion is related to the lack of farm-level data and cost effective

mechanisms for controlling moral hazard.

When making decisions about agricultural risk management programs, policy

makers face a number of constraints. They must consider whether the benefits of

such programs outweigh the costs, and if so, outweigh the net benefits offered by

competing demands on public resources. They must construct the risk

management program so as to minimise distortions in resource allocation and

reduce opportunities for rent-seeking behaviour. They must take into

consideration the status and development of financial and insurance institutions

within the country, any regulatory constraints on the operations of those

institutions, and the infrastructure for enforcing contracts. Finally, it is important

to consider the dichotomy that exists in many countries between smallholder

farms and large farms that produce for export markets.

Policy makers often suggest agricultural insurance programs as an alternative to

free ex post disaster assistance. In principle, insurance programs have many

advantages over ex post disaster assistance. For example, it is often argued that

disaster assistance programs can generate perverse incentives that increase the

magnitude of losses in subsequent disaster events (Barnett 1999; Rossi et al.

1982). But, in practice, agricultural insurance programs have often evolved into

another vehicle for transferring wealth from the public sector to agricultural

producers. Furthermore, there is not much evidence that agricultural insurance

programs have been successful in forestalling free ex post government disaster

assistance. For example, in the United States, more and more costly crop

insurance programs have coexisted with disaster payments for well over 20 years

(Glauber 2004).

Given limited resources in developing countries and the existence of other sectors

that require government attention, these objectives are typically pursued within an

environment of binding fiscal constraints. These objectives target different

segments of people in rural areas and different risk profiles. Growth objectives

focus on increasing profitability so that less poor farmers can continue adopting

production technologies even when high-frequency, low consequence loss events

occur. Poverty reduction policies target the poor and seek to increase their

average income, and decrease the volatility of their income and the likelihood of a

risk event wiping out hard-won asset gains.

Developing countries also have far less access to global crop reinsurance markets

than do developed countries. Reinsurance contracts typically involve high

transaction costs related to due-diligence. Reinsurers must understand every

aspect of the specific insurance products being reinsured (for example,

underwriting, contract design, ratemaking, and adverse selection and moral hazard

controls). Some minimum volume of business, or the prospect for strong future

business, must be present to rationalise incurring these largely fixed transaction

costs. The enabling environment to gain confidence in contract enforcement and

the institutional regulatory environment are critical to create trust that must be

present for a global reinsurer to become involved. These components are largely

missing in developing countries. In fact, a prerequisite for effective and efficient

insurance markets is an enabling environment. Setting rules assuring that

premiums will be collected and that indemnities will be paid is not a trivial

undertaking.

There are various reasons for developing countries to avoid adopting approaches

to risk management similar to the ones adopted in developed countries. Clearly,

developing countries have more limited fiscal resources than developed countries.

Even more importantly, the opportunity cost of those limited fiscal resources may

be significantly greater than those of a developed country. Thus, it is critical for a

developing country to consider carefully how much support is appropriate and

how to leverage limited government dollars to spur insurance markets. In

developed countries, government risk management programs are as much about

income transfers as they are about risk management. Developing countries cannot

afford to facilitate similar income transfers to large segments of the population

who may be engaged in farming. Nonetheless, since a larger percentage of the

population in developing countries is typically involved in agricultural production

or related industries, catastrophic agricultural losses will have a much greater

impact on GDP than in developed countries.

CHAPTER: 3

RISK AND RISK MANAGEMENT

3.1 RISK:

Risk is a concept that denotes a potential negative impact to an asset or some

characteristic of value that may arise from some present process or future event.

Risks are usually defined by the adverse impact on profitability of several distinct

sources of uncertainty. While the types and degree of risks an organisation may be

exposed to depend upon a number of factors such as its size, complexity business

activities, volume etc, it is believed that generally the banks face Credit, Market,

Liquidity, Operational, Compliance / legal / regulatory and reputation risks.

Financial risk is often defined as the unexpected variability or volatility of returns,

and thus includes both potential worse than expected as well as better than

expected returns.

Financial risk in a banking organisation is possibility that the outcome of an

action or event could bring up adverse impacts. Such outcomes could either result

in a direct loss of earnings / capital or may result in imposition of constraints on

bank’s ability to meet its business objectives. Such constraints pose a risk as these

could hinder a bank's ability to conduct its ongoing business or to take benefit of

opportunities to enhance its business.

Regardless of the sophistication of the measures, banks often distinguish between

expected and unexpected losses. Expected losses are those that the bank knows

with reasonable certainty will occur (e.g., the expected default rate of corporate

loan portfolio or credit card portfolio) and are typically reserved for in some

manner. Unexpected losses are those associated with unforeseen events (e.g.

losses experienced by banks in the aftermath of nuclear tests, Losses due to a

sudden down turn in economy or falling interest rates). Banks rely on their capital

as a buffer to absorb such losses.

3.2.1 SYSTEMATIC RISK:

Systemic risk describes the likelihood of the collapse of a financial system, such

as a general stock market crash or a joint breakdown of the banking system. As

such, it is a type of "aggregate risk" as opposed to "idiosyncratic risk", which is

specific to individual stocks or banks.

2.2.2 NON SYSTEMATIC RISK:

Systemic risk should be carefully distinguished from non-systemic risk, which

describes risks which the whole economy faces such as business cycles or wars.

Since systematic risk is caused by factor that affects the whole economy or whole

market therefore it is not possible to be controlled by a person.

3.2 RISK MANAGEMENT:

Risk management is a rapidly developing discipline and is a central part of any

organisation’s strategic management. Risk management evaluates which risks

identified in the risk assessment process require management and selects and

implements the plans or actions that are required to ensure that those risks are

controlled. The focus of good risk management is the identification and treatment

of these risks.

In ideal risk management, a prioritisation process is followed whereby the risks

with the greatest loss and the greatest probability of occurring are handled first,

and risks with lower probability of occurrence and lower loss are handled in

descending order. In practice the process can be very difficult, and balancing

between risks with a high probability of occurrence but lower loss versus a risk

with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of risk - a risk that has a 100%

probability of occurring but is ignored by the organisation due to a lack of

identification ability. For example, when deficient knowledge is applied to a

situation, a knowledge risk materialises. Relationship risk appears when

ineffective collaboration occurs. Process-engagement risk may be an issue when

ineffective operational procedures are applied. These risks directly reduce the

productivity of knowledge workers, decrease cost effectiveness, profitability,

service, quality, reputation, brand value, and earnings quality. Intangible risk

management allows risk management to create immediate value from the

identification and reduction of risks that reduce productivity.

3.3 RISK MANGEMENT PROCESS:

Risk management should be a continuous and developing process which runs

throughout the organisation’s strategy and the implementation of that strategy. It

should address methodically all the risks surrounding the organisation’s activities

past, present and in particular, future.

Risk management is the process of measuring, or assessing, risk and developing

strategies to manage it. Strategies include transferring the risk to another party,

avoiding the risk, reducing the negative effect of the risk, and accepting some or

all of the consequences of a particular risk

3.3.1 RISK IDENTIFICATION:

The first step in risk management is identification of risk. Risk identification can

start with the source of problems or with the problem itself. The source may be

internal or external to the system or organisation.

3.3.2 RISK ASSESSMENT:

Once risks have been identified, they must then be assessed as to their potential

severity of loss and to the probability of occurrence. These quantities can be either

simple to measure, in the case of the value of a lost building, or impossible to

know for sure in the case of the probability of an unlikely event occurring.

Therefore, in the assessment process it is critical to make the best educated

guesses possible in order to properly prioritise the implementation of the risk

management plan. Risk assessment involves identifying sources of potential

harm, assessing the likelihood that harm will occur and the consequences if harm

does occur.

The fundamental difficulty in risk assessment is determining the rate of

occurrence since statistical information is not available on all kinds of past

incidents. Furthermore, evaluating the severity of the consequences (impact) is

often quite difficult for immaterial assets. Asset valuation is another question that

needs to be addressed. Thus, best educated opinions and available statistics are the

primary sources of information. Nevertheless, risk assessment should produce

such information for the management of the organisation that the primary risks

are easy to understand and that the risk management decisions may be prioritised.

3.4 POTENTIAL RISK TREATMENTS:

Once risks have been identified and assessed, all techniques to manage the risk

fall into one or more of these four major categories.

• Retention

• Mitigation

• Elimination

• Transfer

Ideal use of these strategies may not be possible. Some of them may involve

trade-offs that are not acceptable to the organisation or person making the risk

management decisions.

Figure 3.1 Risk Treatment

Frequency of Risk Severity of Risk

Low High

Small Retention Mitigation

Large Transfer Elimination

3.4.1 RISK ELIMINATION:

Includes not performing an activity that could carry risk. An example would be

not buying a property or business in order not to take on the liability that comes

with it. Another would be not flying in order not to take the risk that the

aeroplanes were to be hijacked. Avoidance may seem the answer to all risks, but

avoiding risks also means losing out on the potential gain that accepting

(retaining) the risk may have allowed. Not entering a business to avoid the risk of

loss also avoids the possibility of earning profits.

3.4.2 RISK MITIGATION:

Involves methods that reduce the severity of the loss. Examples include sprinklers

designed to put out a fire to reduce the risk of loss by fire. This method may cause

a greater loss by water damage and therefore may not be suitable. Fire

suppression systems may mitigate that risk, but the cost may be prohibitive as a

strategy.

3.4.3 RISK RETENTION:

Involves accepting the loss when it occurs. True self insurance falls in this

category. Risk retention is a viable strategy for small risks where the cost of

insuring against the risk would be greater over time than the total losses sustained.

All risks that are not avoided or transferred are retained by default. This includes

risks that are so large or catastrophic that they either cannot be insured against or

the premiums would be infeasible. War is an example since most property and

risks are not insured against war, so the loss attributed by war is retained by the

insured. Also any amounts of potential loss (risk) over the amount insured is

retained risk. This may also be acceptable if the chance of a very large loss is

small or if the cost to insure for greater coverage amounts is so great it would

hinder the goals of the organisation too much.

3.4.4 RISK TRANSFER:

Risk transfer means causing another party to accept the risk, typically by contract

or by hedging. Insurance is one type of risk transfer that uses contracts. Other

times it may involve contract language that transfers a risk to another party

without the payment of an insurance premium. Liability among construction or

other contractors is very often transferred this way. On the other hand, taking

offsetting positions in derivatives is typically how firms use hedging to financially

manage risk. Some ways of managing risk fall into multiple categories. Risk

retention pools are technically retaining the risk for the group, but spreading it

over the whole group involves transfer among individual members of the group.

This is different from traditional insurance, in that no premium is exchanged

between members of the group up front, but instead losses are assessed to all

members of the group.

3.5 LIMITATIONS:

If risks are improperly assessed and prioritised, time can be wasted in dealing

with risk of losses that are not likely to occur. Spending too much time assessing

and managing unlikely risks can divert resources that could be used more

profitably. Unlikely events do occur but if the risk is unlikely enough to occur it

may be better to simply retain the risk and deal with the result if the loss does in

fact occur. Prioritising too highly the risk management processes could keep an

organisation from ever completing a project or even getting started. This is

especially true if other work is suspended until the risk management process is

considered complete.

CHAPTER: 4

ANALYSIS

Agricultural finance is faced with many challenges and the most severe challenge

is that of risk management. There are a number of risks associated with

agricultural finance. In the literature review of the report some of the risks have

been highlighted and analysed by different researchers.

In this section the risk associated with agricultural finance are analysed by using

fishbone diagram or cause-and-effect analysis.

4.1 CAUSE-AND-EFFECT ANALYSIS:

Cause-and-effect analysis is a systematic way of looking at the effects and causes

of a problem. In this technique the relationship between dependent and

independent variable is determined through a diagram. The diagram drawn for

this purpose is called “Fishbone Diagram”. The name is because of its shape that

is like skeleton of a fish. Dr. Kaoru Ishikawa, a quality control statistician of the

University of Tokyo developed and it was first used in 1960s. Therefore

sometimes it is also called “Ishikawa Diagram”.

Since Ms. Jennifer Isenhour has used this analysis technique in her research

“ Cause and Effect Analysis of Risk Management to Assess Agricultural Finance”

(2004) therefore the same analysis technique is also used for the present research

to look at the different risks associated with agricultural finance affecting the

overall profitability of agricultural lending institution.

Figure 4.1

Fishbone Diagram

The diagram shows different risk categories affecting the profitability of

agricultural lending institutions. Different factors cause a specific risk, which then

affect the profitability of an agricultural lending institution.

4.2 CAUSES OF LIQUIDITY RISK:

Liquidity risk occurs because of agricultural crops’ seasonality. At the cultivation

period farmers borrow from institutions for meeting their funds requirements for

purchase of seeds, fertilisers, pesticides and labour etc and thus the institution

faces with short of funds while in the harvesting season when the farmers repay

their loans, the institutions are in excess liquidity which cause them liquidity risk.

And another reason of liquidity risk is that of lack of saving and deposits with the

Operational Risk Weather Risk

Market Risk

Profitability of Agricultural lending

institution

Liquidity Risk

Seasonality of agricultural crops

Limited amount of savings

Dispersed rural clientele

Untimely rains or droughts

Lower offer price for crop

Lack of crop insurance concept

Entry of big external players

High servicing cost

bank. This causes the bank the risk of short of funds to lend to farmers for

agricultural purposes.

4.3 CAUSES OF OPERTIONAL RISK:

The people related to agriculture are mostly spread over a vast area in far away

villages. The dispersed agricultural clients cost the bank with higher operational

risk. When a bank want to serve clientele spread over large area or when most of

loan amount is small which is often there in developing country like Pakistan then

it causes the bank with higher servicing costs which result in operational risk.

The bank does not earn that much as it spend on processing, disbursement and

monitoring of agricultural loan.

4.4 CAUSES OF MARKET RISK:

Market risk occurs when the farmer gets a lower offer price for their finished

products in the market than the cost incurred on producing that crop. This causes

a farmer suffer losses as he is not earning that much to repay his loan and

eventually this risk is transferred to the lending institution in form of non-

performing loan. When new external players enter into the market with greater

volume and capital then it results in problems for local farmers. The local farmer

produce at small volume and occupies a small share in the market but when a new

player with huge volume enters into the market then he captures the whole market

and the small farmer cannot survive.

4.5 CAUSES OF WEATHER RISK:

Weather risk is a unique risk involved in agriculture that does not effect other

sectors as much as it affects this sector. Untimely rains, floods, droughts destroy

the crops and result in potential loss to the farmer. Different diseases in animals

can bring potential losses to the farmer-borrower. As in recent time due to bird

flu many poultry farms suffered losses and subsequently the institutions who lend

to them also faced many problems in get their loans paid back. This risk can only

be minimised by taking preventive measures. Crop insurance can be a useful tool

in this regard but is not common in developing country like Pakistan.

4.6 THEIR EFFECT:

All these risks individually and collectively have negative effect on the

profitability of an agricultural financial institution. The weather risk, market risk

minimises the return on loans while the operational and liquidity risk increase the

cost of disbursement loans.

Figure 4.2: Effects on Profitability

Cost on loans

Return of loans

4.7 AGRICULTURAL CREDIT DELIVERY

Agricultural Credit Requirement

& Disbursement by Institutions

The table shows the agricultural

credit requirements and disbursement

by institutions. There is a continuos

increase in the demand for agriculture

credit while the supply of credit is not

increasing at the same rate.

The same figures are plotted on a Source: Journal of Institute of Bankers Pakistan

graph for graphical representation and we can see the credit requirement curve is

on increase while the credit disbursement curve is not following it.

Figure 4.3

Year Requirement Rs in million

Disbursement Rs in million

1990-91 31952 15207 1991-92 39338 14906 1992-93 45636 16896 1993-94 52694 16243 1994-95 62202 22941 1995-96 68569 19774 1996-97 78451 19515 1997-98 102570 32984 1998-99 120000 42847 1999-00 136740 39688 2000-01 145860 44043

During the whole decade the requirement for agricultural credit are consistently

increasing. The reason is the increasing population of the country needs more

food and dairy products which of course agriculture sector is producing. Farmers

need resources for production. The problem is that this increasing demand for

credit is not accompanied by supply of credit at the same rate. This is another

challenge for agriculture finance in agricultural credit delivery.

CHAPTER: 5

RECOMMENDATIONS

The agricultural credit institutions, to protect themselves from risks, should

classify the agricultural sector in terms of risk. The activities with higher loan

default rate because of any reasons should be kept in high-risk zone and activities

with lower loan default rate should be placed in low-risk zone. The financial

institution should first start lending in low-risk zones and then gradually go

towards high-risk zones.

Financial supervision should be strengthened and financial institutions should

keep provisions for loan losses higher than that of other sectors because

agriculture business is comparatively more risky. In this way institutions can

protect themselves against credit risk associated with agricultural finance.

The mind-set of borrowers also needs to be changed. The habitual defaulters

should be discouraged to get the loan or if disbursed then default. This mostly

happens in situations where the borrower does not use the loan amount for the

purpose he has acquired for. So the actual situation should be clear to the lender

by visiting and monitoring.

Diversification has always been a strategy to minimise risk. The same

diversification strategy should be adopted in agricultural finance and loan should

be disbursed to different activities of agriculture e.g. in farm business, non-farm

business, live stock etc. In this case if the borrower suffer losses in one side then

he would be earning profits on other side and would be able to repay his loan.

Similarly the repayment schedules should also be classified in such a way that is

convenient for individual borrower to repay his loan in easy instalments. This

will minimise the credit risk.

For minimising credit risk, information database should be there with the lender

about the credit history and credit worthiness of farmer-borrowers to help in loan

disbursement.

Appropriate collateral should be taken to minimise the risk of default in loans. In

this respect warehouse receipt is very appropriate. The warehouse receipt will

help farmer-borrower to use it as collateral in getting loan for agriculture purpose.

The market risk should be minimised by promoting diversified sources of income

for rural household so that if farmer suffer losses by selling his produced at lower

offer prices then he would be able to repay the loan from his other sources of

income.

Crops are mostly destroyed because of bad weather conditions or diseases that

cause the farmer losses. Crop insurance in this prospect is an excellent idea to

protect crops from unfavourable weather conditions.

In meeting the demands of international markets, farmers will need to produce

commodities according to international standards and qualities. Significant

changes in the production structure may be required in terms of enterprise choice

and the degree of specialisation, adjustments in farm size and integration of farm

production with farm input supply, agro-processing and marketing in the same

commodity chain. Such changes are easier for large rather than small farmers.

CONCLUSION Agriculture sector is Pakistan is growing at upward trend because of increasing

population and this result in increase for credit needs by farmers for the their

agriculture activities but the credit disbursement by banks is not increasing at the

same rate to meet the farmers requirements.

Agriculture is a risky business. Both agricultural specialised financial institutions

and agricultural credit departments of commercial banks are greatly affected by

this and cause them with greater number of non-performing loans and lower profit

margin.

Agricultural lending projects have comparatively poor repayment performance

mainly because of the reason that agriculture business have greater exposure to

weather risk. Market and price are additional risks that are associated with

agricultural finance. Market and price risks are associated with agricultural

finance in the way that many agricultural markets are imperfect that lacks

communication infrastructure and access to the market. It cost a farmer higher to

take his crops to the market because of bad condition of roads, lack of information

and thus result them higher cost of the crops while they have to sell in the market

at competitive price.

In pure perfect market where international players freely enter into the local

market can ruin the local agriculture industry and cause local farmers difficulty in

repayment f their debts because of greater and powerful competition.

Operational risk is associated with agricultural finance in the sense that in case of

small farmer-borrowers spread over vast area, cost higher to serve. The cost of

servicing customers is higher than the profit earned from them. The financial

institutions face with liquidity risk in different seasons. In the cultivation season,

the financial institution faces with shortage of funds to lend out while after the

harvesting season, the financial institutions have excess of liquidity.

Credit risk associated with agricultural finance is influenced by cost and interest

rate margin. The financial institutions are also greatly influenced by political

interference especially in case of state-owned financial institution. Loan write-

offs increase the cost of lending for the financial institution.

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