Agricultural Production Lending

A Training Toolkit for Loan Officers and Loan Portfolio Managers

2010

Revised version

Table of Contents

CONTENTS

Introduction...............................................................................................................................4Chapter 1: Agricultural Lending to Small Farmers........................................................7

1.1 From Directed Agricultural Credit to Rural Financial Market Development.....7

1.2 The Supply and Demand for Rural Lending...........................................................9

1.3 Lessons from Microfinance.....................................................................................10

1.4 Unique Features of Agricultural Lending..............................................................11

Chapter 2: The Challenges of Agricultural Lending....................................................132.1 The Risks...................................................................................................................13

2.2 The Costs..................................................................................................................18

2.3 The Loan Officer......................................................................................................20

Chapter 3: Basic Features of Agricultural Lending.....................................................233.1 Types of Agricultural Loan Products....................................................................23

3.2 Finding Good Customers.......................................................................................24

3.3 Understanding Agriculture.....................................................................................25

Chapter 4: The Agricultural Loan Cycle......................................................................334.1 Steps in the Agricultural Loan Cycle....................................................................33

4.2 The Initial Screening of Loan Applicants.............................................................36

4.3 The Loan Application.............................................................................................39

4.4 The Field Visit...........................................................................................................474.4.1 Repayment capacity...................................................................................................47

4.4.2 Character and willingness to repay a loan...............................................................54

4.4.3. Capital and Loan Collateral......................................................................................55

4.5 Loan Appraisal.........................................................................................................584.5.1 Repayment capacity...................................................................................................58

4.5.2 Character assessment................................................................................................67

4.5.3 Capital.........................................................................................................................68

4.5.4 Collateral.....................................................................................................................71

4.5.5 Environmental analysis.............................................................................................72

4.6 Loan Approval and Follow-up................................................................................734.6.1 The Loan file...............................................................................................................73

4.6.2 Loan conditions..........................................................................................................74

4.6.3 The Credit committee................................................................................................78

4.6.4 Loan disbursement.....................................................................................................79

4.6.5 Loan supervision and monitoring.............................................................................80

2

4.7 Managing Late Repayments and Loan Default.....................................................854.7.1 Loan recovery strategy..............................................................................................85

4.7.2 Preventing and managing late repayment...............................................................86

4.7.3 Managing loan default...............................................................................................90

4.7.4 Improving procedures...............................................................................................94

Chapter 5: Agricultural Loan Portfolio Management.................................................965.1. Individual versus Portfolio Risk.............................................................................96

5.2 Loan Portfolio Risk Factors....................................................................................97

5.3 Measuring Loan Portfolio Quality........................................................................102

5.4 Strategies for Active Loan Portfolio Management..............................................106

Chapter 6: Agricultural Value Chain Finance...................................................................1126.1 Background............................................................................................................112

6.2 Value Chains in Agriculture - Concept and Definition.....................................112

6.3 Interlinked Credit Arrangements.......................................................................113

6.4 Opportunities and Challenges for Value Chain Finance.........................................114

TABLES:

Table 1 Comparison of the Old and New Approach to Rural Finance.........................7

Table 2 Supply and Demand Characteristics of Rural Lending.....................................9

Table 3 Crop Budget Worksheet – Nigeria Vegetables.................................................42

DIAGRAMS:

Diagram 1 The Financial Sector...........................................................................................9

Diagram 2 A typical loan cycle...........................................................................................33

Diagram 3 Analysing loan default......................................................................................91

Diagram 4 Factors influencing regional risks...................................................................97

Diagram 5 Factors influencing Sector Risks.....................................................................99

Diagram 6 Example of the possible links in agricultural value chains:........................113

3

Introduction

Agricultural lending to small farmers in developing countries is particularly challenging and has been a concern of governments for a long time. As a result of the change in approach in the 1990s from “directed agricultural credit” towards a broader view of “rural financial market development” the access farm households have to formal agricultural credit has almost completely disappeared and this situation continues until today.

Banks generally avoid dealing with small farmers, as they perceive lending to them to be both costly and risky. Microfinance institutions, although anxious to extend their operations into rural areas, also worry about how best to provide effective financial services and, in particular, how to lend safely to farm households. Agricultural finance today is at a crossroads: at the same time as more working and investment capital is needed to meet the increasing demand for food, agricultural lending, particularly to small farmers, remains restricted, leading to a demand gap in the provision of rural financial services.

This agricultural lending training toolkit is designed as a self-study manual and training resource for agricultural lending institutions around the world. It highlights the common principles of sound agricultural lending and can be used by loan officers who are dealing with agricultural lending on a daily basis or by desk officers of donor agencies which provide support to local rural financial institutions. It may also be useful as basic reference material for local trainers.

The document is structured as follows:

The first chapter highlights the change in approach from supply-led and subsidized, directed agricultural credit to rural financial market development. The supply and demand components of rural lending are explained and, in recognition of the efforts of microfinance institutions to extend their operations into rural areas, the main characteristics of microcredit and the unique features of agricultural lending to small farmers are summarized.

The second chapter explores the unique challenges of agricultural lending to small farm households, in particular the high costs and risks involved, and emphasizes the need to use strategies which aim to reduce costs and mitigate risks.

Chapter three sets out some of the basic knowledge needed for effective agricultural lending such as, the different types of loan products that might be offered, cost effective ways of identifying good farmer clients, methods of building up a good agricultural database to provide a basis for sound loan decisions and the background and experience needed by agricultural loan officers in rural financial institutions.

Chapter four constitutes the crucial part of the toolkit and it takes the loan officer through the different steps of the loan cycle. Excel electronic spreadsheets with examples of the data that should be collected by the loan officer and the analysis required for effective loan appraisal will be provided together with the toolkit. There will be a need to adapt these sheets to local conditions in order to make them suitable for practical use by loan officers. However, the electronic management information systems of lending institutions on loan accounts should provide loan officers with “real time” records on loan disbursement and repayment, which are indispensable for loan monitoring and follow-up.

The fifth chapter deals with overall loan portfolio risk management, which is of particular relevance to the managers of agricultural lending institutions. Risks present a major challenge in agricultural lending and risk mitigation measures at individual borrower level need to be complemented with overall loan portfolio risk management strategies. Diversification of the loan portfolio to cover different geographic areas, economic activities, types of borrowers and loan products is a common strategy for reducing the high “covariant or inter-related risks” associated with agricultural lending.

4

The final chapter examines the fast development of agricultural value chains all over the world and highlights the importance of traditional interlinked credit arrangements, as well as new ways of developing value chain finance. The chapter closes with a section outlining the opportunities and challenges that value chains pose for financial institutions involved in lending to small farm households.

This toolkit was written by Norah Becerra, Michael Fiebig and Sylvia Wisniwski with support and advice by FAO.

5

The toolkit uses an imaginary lending institution and farming family to illustrate many of the procedures that are being introduced and these are identified by the following icons:

AGLEND:

The AGLEND icon indicates that an example based on the imaginary agricultural lending institution, AGLEND, is being used.

Family Crespo:

This icon indicates when the imaginary family Crespo, clients of AGLEND, are being used as an example.

Other important features of the toolkit are highlighted by these icons:

Case Study:

This globe icon indicates that a real-life case study or institutional experience from a specific country is being used.

Questions:

The clip-board icon indicates that questions to help readers review the key messages of each chapter have been provided.

Exercises:

The paper and calculator icon indicates an exercise section. Here, more complex questions are posed and readers may be asked to give a solution to a specific problem.

Answers to calculations are provided at the end of the toolkit.

6

Chapter 1: Agricultural Lending to Small Farmers

Objective: To provide an overview of agricultural lending and its role in rural development

1.1 From Directed Agricultural Credit to Rural Financial Market DevelopmentThe majority of the rural population in developing countries depends on farming for a livelihood and small farm development is considered important for economic growth and improved food security, as well as the reduction of rural poverty. The provision of agricultural credit to small farmers, however, has turned out to be difficult. Early development planners were primarily concerned with the need to increase food crop production and they used the provision of cheap credit to small farmers as a means to stimulate the adoption of modern, yield-increasing farm inputs. These programs, however, were based on a number of wrong assumptions regarding the nature of the farm households that they targeted and they were also designed in an unfavourable market environment, characterized by heavy government interventions and negative terms of trade for the agricultural sector.

Until the late 1980s large amounts of government and donor money were directed to smallholder farmers for specific production purposes often in the form of a package of subsidized credit, public agricultural extension services and state-controlled agricultural input supply and output marketing. This targeted approach failed, however, to produce increased farm income, as the new technologies and farm inputs were not sufficiently profitable at the prevailing crop prices. Moreover, the agricultural development banks, through which most of the credit was channelled, were unable to operate as sustainable financial institutions and as a result, they have either been liquidated or reformed.

Since then major market liberalization and financial sector reforms have been initiated and significant changes have also taken place in agricultural and rural development strategies. In particular, the earlier directed agricultural credit policy has been replaced by a market-based financial system development approach. Rural financial market development now aims at providing sustainable financial services for the rural population which are responsive to the effective demand for deposit facilities and credit for profitable income-generating activities, including farm, farm-related and non-farm enterprises. The key words for market-based financial institutions are performance, outreach and sustainability.

The table below summarizes the main differences between a directed agricultural credit approach and a rural financial market development approach.

Table 1 Comparison of the Old and New Approach to Rural Finance

Directed Credit Paradigm

(“Old”)

Financial Market Paradigm

(“New”)

Core problem Market imperfections High transaction costs

Role of financial services 1. Help the poor

2. Stimulate production

3. Offset distortions

4. Implement plans

Financial intermediation

Primary providers of rural financial services

State banks and specific farm credit programmes

Different types of commercially viable financial intermediaries

Users of financial services seen as...

Beneficiaries (borrowers) Valued clients (borrowers and savers)

Types of financial products offered Subsidised loans, often directed at Loans with commercially viable

7

specific agricultural crops or farm activities

interest rates for a variety of financial needs, deposit facilities and other financial services such as transfer payments, leasing etc.

Sources of funds Governments and donors Mainly deposits

Subsidies Many (persistent) Few (transitory)

Information systems and evaluations

Dense, mainly for planners.

Focus on credit impact

Less dense, mainly for managers.Focus on performance of financial institution and system

Based on: Coffey, 1998

An important later phase in financial system development has been the emergence of microcredit programmes, which focus on financing short-term and regular income-generating activities of poor people in urban and rural areas. These programmes have demonstrated that low-income clients are ready to pay high interest rates, if the credit offered meets their specific financial needs. At first microcredit was offered primarily by NGOs, but today microfinance has turned into a new line of business for many different types of financial service providers including specialized microfinance institutions, development banks and even private commercial banks. A number of international microfinance investment funds with a pro-poor interest support local microfinance institutions. Important progress has been made in the design of appropriate lending technologies and in institutional sustainability and operational outreach of these institutions.

Microfinance, however, is largely concentrated in urban areas and the majority of small farmers and other rural entrepreneurs in developing counties and transition economies have no access to financial services, mainly due to the highly risky nature of agricultural enterprises. The challenge of how best to develop a viable rural financial system and, in particular, finance small farmers in a cost-effective and risk-reducing way remains open. This is crucial: at the same time as small farmers need more working and investment capital in order to meet an increasing demand for food, agricultural lending remains restricted. As a result there is an important demand gap in the supply of rural financial services.

It is encouraging, however, that a number of microfinance institutions have started to expand their operations into rural areas. Take, for example, the initiative of the Incofin Investment Management Group in Belgium, which launched a Rural Impulse Fund in 2007. This international public-private partnership fund has a capital base of US$ 38 million and provides both loans and equity capital to selected local microfinance partners in an attempt to assist the expansion of their outreach into rural areas.

The following diagram illustrates the overlapping relationship that exists between different components of the financial sector. Attempts to increase the outreach of agricultural financial services to small farmers should benefit from the experience that has been obtained in microfinance. However, the unique features of agricultural lending mean that the best practices of more urban-based microcredit do not transfer easily to rural areas.

8

Diagram 1 The Financial Sector

1.2 The Supply and Demand for Rural Lending

The following table provides an overview of the typical range of business that create a demand for loans in rural areas and the types of lenders that can meet these needs.

Table 2 Supply and Demand Characteristics of Rural Lending

Rural Loan Demand Rural Lenders

Farms: Agricultural production activities

Formal lenders: Development banks, commercial banks, co-operative banks, rural banks, community banks

Agriculture-related small enterprises: Local input dealers and workshops, agricultural traders, small agro-processing enterprises

Semi-formal lenders: Credit unions, co-operatives, village or community banks, NGOs, microfinance institutions

Non-agricultural micro and small enterprises: Small general trading and services activities

Informal lenders: Relatives and friends, money lenders, rotating savings associations, local traders and shops, input dealers

Large agriculture- related enterprises, often based in urban areas: Agro-processors, wholesalers, retailers, exporters

Interlinked agricultural credit arrangements: Agricultural input and equipment suppliers, crop buyers, agro-processing companies, wholesalers, retailers, exporters

9

Urban finance

Ruralfinan

ce

Agricultural

finance

Microfinanc

e

Rural lenders: Commercial banks, which have few or no rural branches, rarely engage in rural lending and, in particular, they do not lend to small farm households. Instead, they focus their attention on servicing large agribusiness clients, who are often located in urban areas. Semi-formal lenders, who usually operate under different regulations, raise most of their funds from short-term savings and this seriously limits their ability to lend to agricultural enterprises which are seasonal and have relatively long production cycles. Informal rural lenders and local businessmen such as traders, shopkeepers and input dealers fill some part of the rural finance demand gap with trade and supplier credit. Their advantages are a local presence and good knowledge of their clients, which enables them to provide convenient and timely access to credit. In general this compensates for the relatively high lending rates and unfavourable terms of trade that they offer. Modern forms of interlinked agricultural credit arrangements such as contract farming are playing an increasingly important role in the financing of small farmer production and are of particular relevance for agricultural commodities that require specialized agro-processing. The increasing importance of agricultural value chains as a means of financing farm production will be dealt with in the final chapter of this toolkit.

Demand for Agricultural and Rural Lending: A number of the assumptions that were made about small farmers in the directed agricultural credit approach have proved to be wrong. Small farm households, even if they are poor, do save and, in fact, precautionary savings form an integral part of farm household livelihood strategies. Savings both in kind and in cash, are used to bridge the period between successive harvests and can be used for a variety of production, consumption and contingency expenditure, as well as for investment purposes. Another misconception was that small farmers would be unable to pay market interest rates for the credit that they need. The widespread use of informal credit, however, has shown that convenient, timely and regular access to small contingency loans compensates for its high costs. Small farmers tend to be risk averse and diversify their revenue generation across a range of farm and non-farm income-generating activities. A close look at the cash flows of low income farm households shows the complex relationships between farm and family household expenditures and revenues. This complexity was not taken into consideration in the directed agricultural credit approach.

1.3 Lessons from Microfinance

The lessons or “best practices” that microcredit programmes have provided relate to the strategies that have been developed to reduce the high costs and risks associated with granting small, short duration loans to low-income clients for income-generating activities, usually trading or providing services.

Cost reduction strategies: The main strategies used to reduce costs are standardization of loan products and the use of streamlined lending procedures. Microfinance institutions generally offer a limited number of highly standardized loan products, usually in the form of short-term working capital loans for microenterprise activities. Loans to first-time clients are small and are granted for terms ranging from a few weeks to a few months. As the information-gathering costs of established clients are considerably reduced, borrowers with good repayment records are rewarded with repeat loans, the size and duration of which are gradually increased. However, as the costs associated with providing very small loans are relatively high, microfinance institutions usually charge higher interest rates than those used by traditional formal lenders. A lean organizational structure helps to reduce the overhead costs of the financial institution, while staff performance incentives schemes are widely used to increase the number of clients that are managed by each loan officer and to improve the loan portfolio quality. Cost and loan quality considerations usually determine whether an institution chooses group lending or individual lending, although over time there may be a trend to more individualized lending methods. Information on the credit history and creditworthiness of potential borrowers is usually sought from relevant local organizations and communities, while a key element of loan appraisal is using household cash flow to determine loan repayment capacity.

10

Risk management strategies: In the selection of borrowers most microfinance providers pay particular attention to identifying a target clientele who have a minimum level of experience and track record in the microenterprise business activity for which loans are given. Loans usually need to be repaid in weekly or monthly instalments, which means the income-generating activities must have a high turnover and generate regular income flows. Door-step banking procedures and delegation of a limited lending authority to loan officers ensure that loan decisions are made by those who are closest to their customers and know them best. As the microcredit target clientele rarely possesses the conventional types of loan collateral demanded by banks, various types of collateral substitutes are accepted for the small and short-term loans, such as household goods, co-signers and third-party guarantors. Graduation of clients to larger follow-up loans creates an important incentive for good loan discipline and loan repayment behaviour.

1.4 Unique Features of Agricultural Lending

The application of microcredit best practices to agricultural lending is limited by a number of unique features of the small farm sector.

Political sensitivity of agriculture: Essential pre-conditions for viable agricultural lending are the existence of sound policies for the agricultural sector and a favourable, market-oriented rural business environment. Food production and food security, however, are highly politically sensitive issues and often dominate agricultural development policies. Thus terms of trade are often distorted to keep the price of basic food products low for urban consumers and this has a negative effect on the profitability of farmers, which discourages financial institutions from serving them. Moreover, as experience from the directed agricultural credit approach has shown, state intervention in rural financial markets, such as enforcing low interest rates for small farmer borrowers or promoting loan default waivers, does not compensate for the low profitability of farming.

Nature of farm lending activities: Agricultural loans are larger and require much longer repayment periods than most microcredit loans. The length of agricultural production cycles means that loan repayments are restricted to large, lumpy instalments, so loan supervision costs tend to be high because of the need for strict loan monitoring. In addition agricultural lending is seasonal, so the work load of loan officers is not even throughout the year. This results in high personnel costs, especially when financial institutions do not diversify their overall loan portfolio sufficiently. The importance of assessing all the different income-generating activities of farm households and the complex inter-relationship between production and consumption expenditure and revenue also contribute to the high information and staff costs for agricultural lending institutions.

High transaction costs of lending in rural areas: Rural areas, unlike towns, are characterized by low population density and an inadequate infrastructure. The fact that potential clients of rural financial institutions are widely dispersed makes the provision of financial services to them very costly. Establishing and maintaining a rural branch network leads to high overhead costs and, while the use of mobile loan officers and door-step banking procedures may reduce the transaction costs of both lender and borrower, it does not resolve the overall problem of high costs. Consequently financial institutions which decide to work in rural areas may initially concentrate their operations in more favourable regions or focus on clusters of profitable business activities. If successful, they may gradually extend their operations to other areas.

High risks associated with agricultural lending: Risks and uncertainties in agriculture are more serious than in most non-agricultural economic activities. The type and severity of these risks vary according to the type of farming systems practised, the prevailing farm enterprises, the quality of individual farm management skills, the local physical and economic conditions, and the effect of government policies. The risk of individual loan default can be serious in environments which have a

11

history of failed agricultural credit programs. One way of reducing the high cost of gathering client information and moral hazard risks in agricultural lending is to collaborate closely with local organizations that can provide reliable information about new clients.

Covariant or inter-dependent risks which may affect many or all farmers in the same location, and at the same time, represent by far the most important challenge to agricultural lending. They arise from both production and market risks. Production or physical yield risks are due to natural hazards such as unfavourable weather conditions, pests and diseases, and they have a negative and unpredictable impact on physical farm production. On the other hand, market risks of agricultural commodities are due to product-specific market fluctuations and changes in domestic and international agricultural and trading policies which have a direct impact on product prices. Rural financial institutions can protect themselves against the potentially devastating effects of high covariant risks in agricultural lending by diversifying their loan portfolio. Other instruments that can be used are insurance products, warehouse inventory credit, contract farming and other forms of vertical integration in the agricultural value chain. In the event of natural disasters, careful loan rescheduling and close coordination with emergency aid organisations may help in reducing the adverse impact of covariant risks on agricultural lending institutions.

Agricultural loan collateral limitations: Small farm households possess few valuable assets that they can pledge as collateral for agricultural loans and this lack of collateral poses specific problems for lenders. For instance, the usefulness of farm land as collateral is limited by problems with ownership titles, uncertain legal procedures associated with foreclosure and weak land markets. Movable assets such as equipment and livestock are regarded as even more risky forms of security, particularly if they are not covered by insurance. As a result, lenders value rural assets very conservatively and they may require a collateral value that is much higher than the loan value. This reduces the effective demand for agricultural loans by small farmers.

Questions:

1. What are the core differences between the old and new approaches to agricultural lending? What consequences does the change have for agricultural lenders and small farmers?

2. Has there been a change in approach in your country? How has this affected the rural financial markets there?

3. What are the major types of organisation lending to agriculture in your country? Which are the main providers in your region?

4. What kind of microfinance institutions operate in your country? Which practices do they follow? Compare the different roles played by NGOs, savings and credit co-operatives, development banks and commercial banks.

5. Which clients do the microfinance institutions serve in your country? Do rural smallholders have access to small loans?

12

Chapter 2: The Challenges of Agricultural Lending

Objective: To increase awareness of the particular risks and costs associated with agricultural lending and identify the important characteristics that an agricultural loan officer needs.

2.1 The Risks

i) Moral hazard

In any lender-borrower relationship, there is a general problem of moral hazard that is the result of specific personal characteristics and decisions of each individual borrower. In this regard, farmers do not differ from any other borrower group in terms of information, incentives, monitoring and enforcement problems associated with the lending process.

Firstly, it is obvious that the lender does not have the same information as the borrower. The latter knows exactly what his/her own management capacity is and how the loan will be used. The lender does not know the potential borrower to such an extent. In rural financial markets, information about low income loan applicants is particularly difficult to obtain. Secondly, even if the loan applicant frankly shares all relevant information for the loan decision, his/her future actions cannot be fully predicted. Therefore, it is crucial for financial institutions to use incentives to encourage borrowers to behave in such a way that repayment is assured.

Thirdly, the farmer may decide to change his/her economic behaviour, invest the money elsewhere or simply move to another part of the country. Many subsidised agricultural credit programmes tried to manage this risk by undertaking regular monitoring of the borrower but this is costly. Finding cost-effective methods for monitoring borrowers is a particular challenge in agricultural lending.

However, there are other risks beyond the general behavioural risks of a borrower. This second category of loan loss risks is associated with the agricultural sector and agricultural production. It refers to factors external to the farmer’s repayment attitude.

ii) The nature of farming

Farming is a risky business. The weather affects productivity and may cause crops to fail. If productivity is lower than expected, farmers may not be able to repay loans. Market prices also fluctuate and are difficult to predict when crops are planted. These risks and many others need to be identified, measured and actively managed in order to prevent lending institutions turning away from a farming clientele. Let's look at the various external risk categories that need to be taken into account in agricultural lending.

Agricultural production and crop yield risks

Crop yields are generally uncertain, as natural hazards such as weather, pests and diseases and other production calamities impact on farm produce. Even slight changes in weather conditions, e.g. less rain than usual, can seriously impact on farm production. Pests and diseases can spread quickly, causing the loss of all or part of a crop’s production. The quality of soil in farming plots and their location are other factors that significantly influence productivity and crop yield risks.

13

Experienced farmers know the specific risk profiles of agricultural products and try to manage these risks. One strategy applied by many small farmers is diversification, as having a variety of activities counters the risk of losing everything if one enterprise fails. Many small farmers are so risk-averse, they do not readily venture into new crops or production methods in which they are, as yet, inexperienced.

Weather impact is managed in various ways. For example, irrigation systems may limit the risk of drought. Greenhouse production - among other benefits – can limit the risk of frost damage and increase overall productivity significantly. On the other hand, however, modern farm technologies can also increase the risk exposure of a farmer if they are little known or poorly managed.

Ways to reduce the damage caused by pests and diseases include the use of insecticides and other chemical products. Animal illness and mortality can likewise be managed through vaccination and maintenance of strict hygiene precautions. Contacting agricultural extension agents or veterinary surgeons for advice may help to complement the farmer’s own knowledge and experience in managing production and yield risks.

In all these risk management techniques, the experience and skill of the small farmer are core requirements for good results. In fact the risk of inappropriate management is another element of production risk. So, prudent lending decisions need to include an assessment of the management capacity of the farmer.

Seasonality of agricultural production constitutes another important risk. People invest in work today for a future return in the form of a crop harvest several months after planting. If the harvest is poor and not enough to see people through to the next one, they will be weakened by malnutrition and in extreme situations can die from starvation. A particular feature of seasonality risk is the fact that, if in a given season part or all of a crop is lost, new planting often has to wait until the start of the following season. Besides which, funds for investing in additional agricultural inputs for a new production cycle may not be available. Complying with the repayment schedule for a current seasonal loan may also become impossible, if other sources of income cannot be mobilised.

Price and market risks

Price uncertainty due to market fluctuations is particularly significant where market information is lacking or scarce or where markets are imperfect – features which are prevalent in many developing countries. The relatively long period of time between planting a crop or starting livestock activities and obtaining the final product makes it likely that market prices will have changed considerably from that originally foreseen. This problem is particularly relevant to long term agricultural production activities, such as perennial tree crops like cocoa or coffee, where several years pass between planting and the first harvest.

Price fluctuations may be particularly severe in export markets, but under- or over-production of crops will also influence domestic market prices to a significant degree. In many countries, price uncertainty has increased with the liberalisation of agricultural markets. In the past state controlled marketing boards often set fixed prices, but today agricultural prices are left to fluctuate freely in many countries. Private crop buyers rarely fix a blanket-buying price prior to harvest, even though inter-linked purchase and credit arrangements for specific crops have become more common. These arrangements almost always involve setting a fixed price or a range of prices prior to planting.

Another source of market risk is the potential losses that arise when marketing agricultural products. Transportation, for instance, is a major challenge in many rural areas and substantial losses or damage may be incurred as a result of inappropriate storage facilities. The lower quality of a poorly stored product also reduces its price.

14

Lack of diversification

Price and market risks, as well as production and yield risks, are often higher for farmers who specialise in a single crop or livestock activity. Accordingly, many farmers diversify their production and apply risk mitigation techniques to reduce their risks. Complementing farm production for market with food production for subsistence is a livelihood strategy used by most small farmers and this assist their survival if production and price risks wipe out expected profits.

Small farmers’ annual incomes often depend on one main crop enterprise. This is particularly challenging when it takes many months to reach harvest time. The situation is even more difficult if the farmer's plots are very small. Thus, an alternative approach to diversification is to generate additional household income between agricultural seasons by engaging in off-farm activities. This can be essential for farmers who are operating in a high-risk agricultural production environment, e.g. when they face a continuous threat of drought or floods.

While diversification of agricultural production is very common, its effect on reducing income insecurity is often insufficient. In fact, small farmers have a long history of experiencing bad years during which their cash income is close to zero, interspersed with some better years, in which a small surplus may be produced. As income risks directly affect the outcome and repayment of an agricultural loan, a lack of sufficient production diversification and risk mitigation remains a major challenge for agricultural lending.

iii) Politicians

Political interference in agricultural markets is a common feature which is found in many developing countries. Price intervention is popular for example, as low food prices are in the interest of the urban population which has a loud voice. Abolishing price ceilings for basic food products in former socialist states led to severe social unrest. Accordingly, stabilising food prices has been a common feature of political interventions in many countries. On the other hand, fixed farm gate prices for agricultural products are also frequently used by governments to ensure a minimum level of income for small farmers.

Changes in policy and state interventions can have a severely damaging impact on rural financial markets. Agricultural lending has, in fact, a long-standing history of political intervention and market distortion, which has significantly contributed to the lack of interest from commercial banks in lending to farmers. Promising debt cancellation is a common feature of populist political campaigns and is extremely damaging to the operations of viable financial services providers. Even well-intentioned credit programmes earmarked for specific target groups and regions can substantially distort prudent agricultural lending.

Have a look at the following example:

15

Political Risk in Thailand for theBank for Agriculture and Agricultural Co-operatives

A key component in the presidential electoral campaign of Thaksin Shinawatra was a three-year debt suspension plan for farmers. The debt relief programme allowed Thai farmers to stop loan principal repayments and interest payments for a period of three years. This was going to affect the Bank for Agriculture and Agricultural Co-operatives (BAAC), the largest financial institution in Thailand servicing rural households, quite badly. In order to reduce the expected negative implications of this programme on its financial viability, the management of BAAC negotiated with the government and achieved the following results:

Only farmers who had borrowed less than 100,000 Baht (2,300 USD eq.) and who had never had any legal action taken against them by BAAC in the past, would be eligible for the debt suspension programme.

The Thai government would compensate BAAC for all lost interest payments during the three-year period.

Borrowers who opted for the debt suspension programme would not be allowed to obtain any new loans from BAAC.

Borrowers who decided to repay their loans before the 3-year due date of the programme would be promoted to a better credit rating client category.

Around 50% of BAAC’s active borrowers, i.e. 1.1 million farmers were registered under the debt suspension programme. However, the negative impact of the programme was largely off-set by stimulating on-time loan repayment with appropriate incentives and by charging any additional costs and potential losses to the government.

Based on Haberberger and Wajananawat (Bangkok Post October 2001)

Unfortunately political intervention in rural financial markets often creates market distortions, which can have a long-term impact on both the borrowers’ willingness to repay loans at commercial rates and the willingness of commercial lenders to engage in new lending. Government intervention, therefore, can create or reinforce the distorted market environment it wishes to overcome.

iv) Collateral problems

If a borrower does not repay on time, a lender must enforce repayment. In traditional bank lending, collateral is used to compensate for potential loan loss. Small farmers, however, rarely have conventional types of collateral and legal procedures to use collateral are often cumbersome and costly. Developing and applying effective and cost efficient enforcement mechanisms is, therefore, another challenge facing those wishing to control loan loss risks in agricultural lending.

Small farmers rarely possess land titles which can be used as loan collateral by banks and if they do have a title, it may have a very limited commercial value, due to the absence of a rural land market. Land registration is often imperfect in developing countries and land titles may be unavailable or costly to obtain.

Here are some examples:

16

Land as Collateral in Latin America

In Brazil, land cannot be the subject of a mortgage, unless the farmer owns a second piece of land. Alternatively, the farmer can mortgage just half of his land.

In Bolivia, the law does not permit the pledging of small plots of land for a mortgage. This rule was part of the agricultural law reform, which was introduced to protect small farmers from becoming over-indebted. At the same time, however, it adds to the exclusion of small farmers from access to loans.

If farmers possess a small piece of land in Honduras, land titles are very difficult to obtain, as county borders are not clearly defined throughout the country. The National Institute of Agriculture, however, can only provide land titles for land that is used exclusively for agriculture and is bigger than one hectare. Small farmers therefore find it difficult to obtain legally certified property rights from their county administration.

In response to this limitation, lenders may have to accept other types of farm assets, such as livestock and equipment, as loan collateral, even though there is more risk attached to these, particularly if they are not covered by appropriate types of insurance. Microfinance institutions use a combination of different types of collateral that vary with the loan size, and personal and third party guarantees and co-signing by a spouse are often accepted as alternative or collateral substitutes to “real” assets. Group guarantees are also used in agricultural lending and this approach is based on functional social control, mutual trust and joint liability by group members.

A better approach may be to focus on the use of preventive measures to secure loan repayment. These measures put less emphasis on the provision of collateral and more on the importance of adequate appraisal of the loan applicant and his business, and close follow up and monitoring. Moreover, loans should be designed in such a way that they stimulate good repayment discipline, for example by providing access to larger loans in future or by offering the possibility of obtaining parallel loans.

Questions:

1. What kinds of risk affect agricultural lending? Is there a relationship between the risks farmers face in agricultural production and the risks of lending to them? What other risks do lenders have?

2. Which of the following affect production risks:

concentration on one crop; soil quality; livestock diseases; weather changes; lack of water; the farmer’s experience?

3. Identify the most important factors that influence the price and market risks of the five major agricultural products in your country.

4. How do politicians influence the moral hazard risk? Have they affected rural financial markets in your country?

5. What are the limitations of using farm land as loan collateral in your country?

17

2.2 The Costs

Lending to small farmers is generally a costly business. Clients are normally widely dispersed and long distances have to be travelled by loan officers and/or customers. The costs of loan appraisal, follow up and monitoring are more or less fixed and do not vary with the size of a loan, which makes it relatively more costly to administer small loans in comparison with large ones.

The key factors that determine lending costs are the need to collect detailed information about a potential borrower and his business and the need to monitor loan use closely. Information is vital in assessing and managing risks. Good client information serves as a partial substitute for a lack of collateral assets and as a means of countering moral hazard. However, in rural settings it is often difficult to obtain good information on potential clients.

Let’s have a closer look at some of the factors that influence transaction costs for agricultural loans:

i) Lack of credit history information There is a general absence of credit history information, as few financial institutions offer the possibility for rural people to build up track-records on their loan behaviour with them. Also there is an absence of credit reference bureaus in rural areas that collect and store information on borrowers.

To initiate a relationship between an agricultural lender and a client, therefore, is particularly costly and involves substantial “start-up” information costs. The financial institution itself must capture key information from the borrower, which requires time and experienced staff. Once loan track records have been established with an agricultural lender, client information costs diminish considerably. In order to achieve these economies of long-term relationship, the financial service provider must have an appropriate client information system and a comprehensive database which tracks customer performance and cost and risk profiles of their economic activities.

ii) Lack of farm records Small farmers usually have a low level of formal education and are not used to keeping documents and written records. Consequently, loan appraisal must often be based on information that is obtained by interviewing potential borrowers.

iii) Individuality of farm household clients

The heterogeneity of agricultural production conditions and the unique combination of farm and non-farm economic activities of each farm household, calls for a thorough, highly individual approach to loan appraisal. This need for carrying out a tailor-made agricultural loan analysis, which caters for the complexity of and the inter-relations between different farm income sources and expenditure requirements, is rather cost-intensive. It involves employing location and farming system specific loan appraisal techniques, loan product design and loan disbursement and repayment schedules.

iv) Farmers’ sensitivity to client transaction costs

Small farmers are particularly sensitive to high client transaction costs such as travelling to bank offices. Particularly during peak periods in the agricultural season, for example during planting and at harvest time, farmers face a heavy workload, which makes it difficult for them to spend time and money on visiting the offices of financial institutions. Successful agricultural lenders, therefore, often offer door-step banking services and visit clients at their homes or in their fields. Consequently, agricultural loan officers need to travel extensively. This leads to high costs for transport, personnel and other costs such as accident insurance.

18

Other rural financial institutions try to get closer to their customers by maintaining an extensive branch network. Establishing offices in rural areas lowers the transaction costs for the borrowers, but increases the overhead costs of the financial institution. Balancing both cost sides is a major challenge.

v) Seasonality of agricultural production

Typical agricultural production cycles mean that agricultural lending is a highly seasonal business. Given the fact that seasonal agricultural production activities are very time-sensitive, loan appraisal must be carried out within a short period of time and timely loan disbursements must be ensured. Consequently, agricultural lenders must adjust their institutional capability to these changes in workload during the year. There might be a need for employing additional, temporary staff in financial institutions during peak periods while in other months a reduced workload in agricultural lending must be off-set by involvement in other non-farm lending activities. Cost-effective staff and work load planning is therefore a challenging endeavour for agricultural lending institutions.

vi) Cost reducing strategies

Given the complex combination of risk structures and high transaction costs in agricultural lending, cost efficiency becomes essential. Thus, the implementation of highly streamlined policies, procedures and tools in agricultural lending is a must. However, standardisation of lending procedures has to be balanced by the need to meet the specific requirements of a diverse farmer clientele and the financing requirements of the different economic activities within each farm household. The following list summarises various approaches that may help to reduce the transaction costs of agricultural lending while maintaining a healthy overall loan portfolio:

Decentralisation of limited lending approval authority to branch managers and loan officers.

Delegation of parts of the loan appraisal, disbursement and supervision procedures to intermediary organisations that are in close contact with the borrowers, e.g. community groups and farmers organizations, local authorities and leaders, other agricultural support service providers, agricultural extension staff and business development centres, etc.

Definition of borrower eligibility criteria which will assist in the initial screening of loan applicants and eliminate at an early stage those who may be unable or unwilling to repay.

The use of standard loan appraisal formats and assessment indicators, the principles of which will be set out in the next chapter. Example computer spreadsheets for loan analysis and loan planning by loan officers will accompany this agricultural lending toolkit.

Reducing the transport costs of loan officers by using motorcycles.

Adoption of appropriate work and route-planning for loan officers in order to avoid excessive travelling costs.

Using staff performance evaluation and incentive schemes for loan officers and branch staff to encourage operational quality and efficiency.

19

Questions:

1. Summarise the key cost drivers in agricultural lending.2. Review measures to reduce the transaction costs in agricultural lending.

What implications do these measures have on loan default risk?

2.3 The Loan Officer

The knowledge, skills, experience and personality of the loan officer are the key to success in agricultural lending. Good loan officers are the “engines” that drive financial institutions. Loan officers should be in charge of the full loan cycle, i.e. they should be responsible for a loan all the way from the initial client visit until the loan is completely recovered. This has several advantages:

The loan officer is accountable for his/her own loan portfolio. If a loan becomes overdue, the loan officer who recommended or approved it carries the responsibility. He/she cannot blame others for being responsible for a bad loan and cannot delegate problem loans to other staff members.

Loan officers are the “human face” of the financial institution. They should establish a personal relationship with each borrower, which is particularly important for rural people. Confidence and mutual trust can only be established on a personal basis. The loan officer’s personal knowledge of clients is also important as loan decisions are taken not only on the basis of “hard facts”, but also on the officer's judgement of loan repayment willingness and the client’s management capacity.

As we have already noted, rural lenders rarely have access to credit reference systems – or if they exist, these systems give little or incomplete information about farmers' credit histories. Therefore, the loan officer who builds up an “institutional memory” of clients is particularly important in a rural context.

In addition, a data bank cataloguing the physical and economic characteristics of farming activities with their typical risk profiles in the geographic area of a bank branch office can only be built up with the support of the loan officers.

So, to be effective, agricultural loan officers need some quite specific skills, knowledge and personal qualities. For obvious reasons, the details of loan officer job profiles will vary from institution to institution and from regional context to regional context. However, we can look at an example of how a rural financial institution specified what it expected of its agricultural loan officers:

1. Loan officers must be ready and willing to spend the majority of their time outside the office, working in the field. They should be able to cope with uncomfortable working conditions in a rural environment.

2. Loan officers must have good communication skills. Since little or no written records are available in farm households, key information must be obtained by talking to people. Therefore, the ability to speak the local language or dialect is crucial. Loan officers must also be good listeners and able to detect information inconsistencies.

3. Loan officers must be able to make sound judgements and have the confidence to take appropriate decisions and actions.

4. Loan officers need a basic knowledge of agricultural production and economics. Practical experience is more important than academic knowledge. Thus a university degree in agricultural economics is not sufficient, unless combined with experience of working on farms.

5. Loan officers must be willing to work flexible hours. Farmers are used to starting their work very early in the morning and rural markets often take place at weekends, so loan officers will have to ensure that their work plans fit the time frames of rural life.

6. Loan officers must have basic accounting skills and be able to carry out calculations quickly when they start. However, experience with loan appraisal, including the construction of cash flow projections and balance sheets, and using computer spreadsheets, will be built up on the job.

7. Loan officers should have a motorcycle driving licence, as most clients cannot be reached by public transport or walking.

It is clearly quite a challenge to be an agricultural loan officer!

20

Questions:

3. Do you agree that “loan officers are the engine of a financial institution”? Why do people think so?

4. Can you define five key skills and personal characteristics that you think a loan officer in your institution should have?

5. How important is higher education when hiring loan officers for agricultural lending?

6. What are the advantages or disadvantages of training former agricultural extension staff as loan officers?

In the next chapter, we will start to use the imaginary financial institution, AGLEND, and the imaginary family Crespo, in order to illustrate many of the points we are making. Although AGLEND is based on a real life rural financial institution, it is important to remember that it is not a model or blue print for all situations. It simply provides you, the reader, with a concrete example to study and from which you may be able to develop solutions that are appropriate to your own context.

Here is some background information about AGLEND and the family Crespo:

AGLEND is a financial institution that was founded in the early nineties as an NGO-based microcredit organization. In the beginning, its target clientele were micro and small entrepreneurs in the urban area. However, since the majority of the population in the country live in rural areas, AGLEND decided to diversify its loan portfolio and provide loans to rural households as well. To do this effectively they redesigned their lending technology to suit the new market.

AGLEND followed a gradual approach by offering loans to rural entrepreneurs outside the agricultural sector first and then moving on to farm households and agricultural production. They started the agricultural lending operations in the valleys where good irrigation systems and physical infrastructure exists. From there, they moved on to other regions and now they have rural branches in the tropical lowlands, along the coast and in the highlands.

The farm households that get loans from AGLEND mainly produce cereals (maize, wheat, rice etc.), coffee and vegetables. There are also a considerable number of cattle farms (dairy and meat production). Most of them also obtain additional income from non-farm or off-farm economic activities.

AGLEND started with one basic loan product, an “equal monthly repayment” loan. However, they are now introducing more flexible loan terms, allowing repayments with varying amounts and less frequent instalments.

At present, AGLEND’s average loan size is USD500 for crop production and USD1,000 for cattle breeding.

21

The Crespo family farm at Eagle’s Peak, which is a small village in an Andean valley, about 15 km away from the district capital. Pedro and his wife, Maria, have three children, aged between 15 -20 years who live with them on the farm. The only daughter will marry soon and leave the farm. The two sons work occasionally as construction workers in the district capital, as does their father Pedro.

The family owns 4 hectares of fertile land. Two hectares are used for wheat production, one for sunflower and one for maize. In addition, Maria has a small garden close to the house, where she cultivates vegetables and flowers that she sells at the market in the district capital.

The family owns two oxen that are used primarily for ploughing. There is also one milk cow and a heifer. In addition, Maria keeps five hens. The milk and eggs are used just for family consumption and are not sold.

22

Chapter 3: Basic Features of Agricultural Lending

Objective: To introduce the main types and features of agricultural loan products and suggest ways that staff can build up knowledge about the agricultural sector and its markets, and identify good customers.

3.1 Types of Agricultural Loan Products

Loans to farmers can be provided for different purposes and with different lending terms. The most common loan types are:

Seasonal Loans for Working Capital. These loans are used to buy agricultural production inputs such as seeds, fertiliser and tools, as well as financing operating costs such as wages for hired farm labour. It is important that these loans fit in with the seasonal nature of agricultural production. They are usually short term, lasting only a few months.

Harvesting Loans. These are short-term loans used to hire labour or machinery at harvest time. They may also be used to finance other marketing costs.

Medium term Improvement Loans. This type of loan is used to invest in durable improvements to increase farm productivity, such as the installation of water pumps for irrigation. They are generally repaid over a period of 1-2 years.

Long term Investment Loans. These are loans which are used to purchase farm land or farm machinery for long-term use, such as tractors. Other uses for long term loans include buying breeding livestock and financing the establishment of perennial crops such as coffee, fruit trees or rubber trees that will require several years before they generate returns. Repayment periods usually extend over many years.

Loan duration

As you can see, loan terms range from a few months to a few years. The definition of whether a loan term is short, medium or long differs from country to country and from institution to institution. A possible classification refers to short term loans as loans with a repayment period of up to 12 months, medium term loans up to 36 months and long term loans beyond 36 months.

Medium and long term loans are more difficult for farmers to obtain, as they involve substantially higher risks for the agricultural lender. Establishing a long term client relationship, however, can reduce default risk and provide lending institutions with the information needed to assess other longer term investments in the future.

Disbursement schedules

Whether an entire loan amount is disbursed in one or several instalments will vary according to the loan purpose, i.e. the activities that they are meant to finance. In the case of wheat production, for example, there are different financial needs during the crop production cycle. At the beginning of the cycle, seeds are purchased. During the growing period, fertilisers and pesticides are applied at different times. At the end of the production cycle, there may be a need to finance extra labour or the hire costs of harvesting and threshing machinery.

Generally, loan disbursement and repayment schedules should reflect the actual situation of a farm household, with both disbursement and repayment based on the cash-flow situation. Therefore, the design of agricultural loans requires good information about clients’ financial needs and patterns of loan demand, the mix of agricultural activities involved and their associated cash-flows and risks.

23

Farmers do not only need finance for agriculture, but also for many other non-farm economic activities and household consumption. Thus they may need loans for:

Working or investment capital for non-farm enterprises;

Consumption purposes between planting and harvest;

Special events such as medical costs, school fees, weddings, funerals, etc.

Diversifying their loan portfolio over these different financing needs allows rural financial institutions to balance the seasonal nature of agricultural lending. While farm production loans will always be characterised by seasonal peak demand periods during the year, a lending institution with a diversified loan portfolio, including non-agricultural loans, will be able to manage their liquidity and profitability planning more easily.

Credit Lines or Overdrafts

A credit line or overdraft facility that allows farmers the flexibility to draw funds when they need it up to their allowed credit “ceiling”, which is equivalent to an approved loan amount, might offer a better solution for farm finance. However, credit lines can be more complex for financial institutions to manage and smaller institutions tend to stick with fixed term loan products for specific purposes with defined disbursement and repayment schedules.

Questions:

1. Which types of loans do small farmers usually ask for in your country?

2. Under what circumstances might a financial institution consider giving more than one loan at the same time to a client?

3. Do you think that your financial institution could manage credit lines for farmers?

3.2 Finding Good Customers

Financial institutions have to market their products like any other business. To build up an agricultural loan portfolio, therefore, it is important to undertake the promotion of agricultural loans in ways that ensure the prospect of capturing clients who have a sound income and risk profile, even though the first concern may be to reach out to small farm households.

Let's look at how AGLEND targets its marketing efforts at high potential clients, thus securing good customers in a cost effective and efficient way.

1. They hold regular meetings with well-established irrigation co-operatives.

In the valleys, many farmers have formed irrigation co-operatives that distribute water rights to their members, for which they pay a fee. There are some well-managed irrigation co-operatives, while others operate poorly. The former have good irrigation systems, while those of the latter are in poor condition and do little to enhance farm production. Farmers who are members of the

24

well-organised irrigation co-operatives are more likely to be good borrowers than the farmers in the poorly-performing irrigation co-operatives. So AGLEND regional credit managers regularly attend the meetings of the well-managed irrigation co-operatives and provide information about the loan products of the institution. Farmers who are interested in obtaining loans can immediately submit loan applications.

2. They maintain close links with marketing co-operatives

There are several marketing co-operatives that support small coffee and rice producers. Farmers that are registered with these co-operatives have several advantages that enhance their income and risk profile. They have access to good storage facilities that help to preserve the quality of their crops. The co-operatives test the crop quality and certify it. Thus co-operative members find it easier to sell their crops and get better prices than farmers who sell their products on their own. AGLEND uses these co-operatives as a conduit for the marketing of their financial services. AGLEND loan officers participate in co-operative meetings, but also visit individual co-operative members to provide information on their financial services.

3. They liaise with dealers and shops that sell high-quality agricultural inputs and farm machinery centres that hire machines out to farmers.

AGLEND keeps contacts with well-known agricultural input supply and farm machinery business enterprises in the same way as they do with marketing co-operatives. From the farmer customers of these enterprises, AGLEND can identify reliable potential borrowers with suitable income and risk features. For example, farmers who buy internationally certified seeds and plastic sheets for covering crops should be able to generate higher incomes than producers who do not use these types of yield increasing agricultural inputs.

4. They try not to lose customers.

It is important from an institutional and economic perspective that the lender/borrower relationship does not end with loan repayment. Rather, loans should be seen as part of an on-going client relationship, ideally involving a range of financial products which cater for differing client needs. Once a loan is repaid, AGLEND loan officers seek an opportunity to speak with the client about future loans or the need for other financial products.

Questions:

4. With what local organisations and business enterprises should your financial institution liaise in order to identify good customers for agricultural loans?

3.3 Understanding Agriculture

A thorough understanding of the agricultural sector is a fundamental prerequisite for lending successfully to farm households. Sound knowledge of crop and livestock markets, production methods and external factors that can have an impact on agricultural production, is essential for loan officers, if they are to understand the income and risk profiles of potential clients. Such knowledge will help them to select good customers and make better loan appraisals, thus enhancing their loan portfolio quality. It will also enable the financial institution to design loan products that meet farmers' needs better and set appropriate loan conditions in terms of disbursement, repayment schedules and interest rates.

25

In order to build up their knowledge of the agricultural sector, lending officers of rural financial institutions are advised to establish a comprehensive database of key information on the agricultural production systems in their area, the economics of new technologies, agricultural commodity markets, and the risk profiles associated with specific agricultural production methods and products. During the loan appraisal process, it is of particular importance to be able to compare the information collected from loan applicants with that of an “average” farm household engaged in a similar activity in the same climatic region in order to decide whether the planned expenditures and expected income revenues are realistic or not. This type of data must be collated region by region, because the characteristics of agricultural activities vary from one location to the other. So an information database needs to include:

a. Production activity calendars for agricultural enterprises;

b. Efficiency or productivity indicators, e.g. yields per hectare for different crops;

c. Purchase prices for agricultural inputs and sales prices for agricultural products;

d. Weather information, e.g. rainfall data.

In the rest of this section we will look at some of the information sheets that AGLEND loan officers use as reference material when dealing with agricultural clients.

Production activity calendars

Production activity calendars provide an overview of the main activities associated with a particular crop or livestock enterprise. These calendars can provide insights into several key issues. Firstly, they make it possible to identify the months with a particularly high workload or demand for financial resources. By comparing this with the actual situation on a particular farm, a loan officer can ascertain whether the farm household is able to procure inputs when needed or whether it faces a problem at certain times. Secondly, when the actual work calendar for a potential borrower is compared with a “standard” production calendar, information will be obtained about the farmer's level of production skills. If, for example, important production activities are not undertaken by a particular farm household, this suggests a potential impact on the quantity and quality of crops or livestock they produce. Thirdly, when combining this information with weather forecasts, it is possible to identify critical moments of increased risk in exposure to calamities.

Here is the pig production activity calendar that is used by AGLEND:

Pig Production in HighlandsMonths

1 2 3 4 5 6 7 8 9 10 11 12

Vaccination: pneumoenteritisVaccination: foot and mouth disease

Vaccination: brucellosisDe-worming

Vaccination: erysipelasProvision of vitamins

Anti-rabies inoculationMating

Birth

Efficiency indicators

26

There are a number of indicators which can be used to measure the physical (and when combined with prices, the financial) performance of a farm enterprise. If these indicators are calculated for the farm of a potential borrower and compared with an average calculated for a group of farm households of the same size, type and locality, then this can help to determine whether the farmer has the management capacity to expand his activities and maintain a good enterprise performance. Such comparisons can also identify production problems or indicate results that may be achieved in particularly favourable conditions.

These are examples of efficiency indicators collected by AGLEND:

Dairy Cows

Milk yield per year > 1,500 kg

Milk fat Above 3.0%

Pigs

Pigs per breeding sow per year > 18

50 kg weight gain attained per porker < 4 ½ months

Feed conversion rates for fattening pigs < 3.5 kg food per kg weight gain (3.5 : 1)

As production conditions can vary considerably across regions due to different soil and climatic conditions, efficiency standards should be determined for each region.

Prices of inputs and sale prices of crops

Price information on agricultural inputs and crops makes it possible to calculate the profitability of farm enterprises. In addition, historical records of prices provide insights into price trends and the level of sensitivity in net income that can be expected as a consequence of price volatility in input and output markets. Here is some example price information that AGLEND has collected over a 4-year period:

Input prices in $ Year 1 Year 2 Year 3 Year 4

Fertilizer– Greenzit (NPK 17-17-17) (1 litre)– Compound Fertilizer (NPK 23-23-0) (50 kg)...

8.7031.50

9.1033.75

12.7041.95

13.1545.50

Herbicides– Gesagard (1 litre)...

12.50 12.80 13.05 24.95

Fungicides– Dithane FMB (1 litre)...

8.25 8.80 9.20 15.80

Seeds– Carrots (Chantenay, 1 Pound)– Tomato (Ace Royal, 1 Pound)...

15.50115.50

15.75108.75

16.10110.50

19.55137.50

27

Crop prices in $ (per 100 kg) Year 1 Year 2 Year 3 Year 4

Coffee (previous years: $ 68.00-85.00) 35.20 31.65 36.10 35.95

WheatRice Maize

16.509.909.35

15.7510.655.45

16.2511.206.10

17.1011.056.00

CarrotsTomatoes...

29.4528.15

30.4043.50

46.7020.30

53.9045.75

As prices can be volatile and sharp price variations frequently occur from one month to another, crop prices should be collected on a monthly basis.

Weather information Weather conditions have a strong impact on agricultural production.

Rainfall is one of the most important factors for crop growth. A lack of rain prevents farmers planting new crops, while growing crops may wilt and die or they may not yield as expected. It is essential that there is enough rainfall to meet crop growth requirements and the rainfall must be correctly distributed during the crop’s growing season. Therefore rainfall must be reliable both in terms of quantity and timing. If rains are delayed or come too early, it normally results in poor crop yields. In areas where the rainfall is unreliable, adequate provision of water may be assured through irrigation systems.

Temperature affects agriculture in a number of ways. Each crop has an optimum range of temperature for its growth. If the temperature falls below the minimum, crop production is seriously affected. Temperature affects the incidence of diseases in crops. It also influences the biochemical growth processes, which have an impact on the rate of growth, crop maturity and crop quality.

Natural calamities like floods, hurricanes or drought do hit some locations with a certain frequency. In Bangladesh, for example, the lowlands are flooded every year and there have been major floods affecting the majority of the country every 5-10 years. Natural calamities have a devastating effect on the agricultural production and large parts or even the total harvest can be destroyed.

Most countries collect weather information that is available to the public.

On the following page is an example of rainfall records kept in the AGLEND office for a series of years. The figures show the actual rainfall per year expressed as a percentage of the average rainfall over the last 20 years, which is shown in the first column.

28

Precipitation by region

RegionsAverage of last

20 years,mm

Year 1% *

Year 2%

Year 3%

Year 4%

Year 5%

Year 6%

Year 7%

Year 8%

Year 9%

Highlands

A 612 114 94 38 95 30 94 95 39 99

B 309 83 84 37 82 28 84 89 35 65

C 356 83 79 36 66 39 87 82 40 85

Valleys

D 482 95 70 68 84 51 82 79 82 80

E 650 127 58 96 97 97 98 62 106 99

F 614 94 98 94 103 91 98 96 91 92

Tropical lowlands

G 1,244 114 98 100 109 115 110 104 105 98

H 1,193 90 66 114 90 86 90 71 91 87

I 1,122 183 87 117 117 150 107 122 130 141

Regional enterprise profiles

AGLEND has constructed enterprise profiles as reference material for its loan officers. These profiles summarise the most important facts and figures for each of the main agricultural production activities in the geographic regions where AGLEND works.

Each enterprise profile is based on real data collected from farmers in the selected areas. While agronomic information from agricultural research centres can be used for these profiles sheets, they must be always checked with farmers in order to ensure the data is realistic. Enterprise profiles should take into account regional variations and differences in production methods and cultivation practices used by larger and smaller farmers. AGLEND’s enterprise profiles are regularly updated by providing incentives to the agricultural loan officers to gather additional information and/or adjust existing information on a continuous basis.

Here is an example of a regional enterprise profile prepared by AGLEND.

Vegetable production in the Pramot region

1 General information

Vegetable production is common in nearly all the farms in the Pramot region. In the Krain area the former swamp area was drained and irrigation systems have been constructed. This has given rise to the establishment of several vegetable canning factories in the region. Irrigation systems, however, are in a state of disrepair.

29

2 Minimum conditions for vegetable production

2.1 Environmental conditions

Besides land, access to water for irrigation is a key factor. Small plots of land are sufficient for vegetable growing.

2.2 Production skills In order to grow, transplant and manage quality vegetable production, specialist knowledge is necessary. This knowledge can be obtained either through formal agricultural education, specialized manuals or from family and friends. Strong competition exists among producers of early vegetables, because the first products to reach the market get the best prices. Knowledge gained by experience is, therefore, jealously guarded.

2.3 Capital Initial capital requirements are substantial for growing early vegetables. It includes the construction of a hotbed and greenhouse, together with the purchase of plastic sheets, imported seeds and fuel expenses.

2.4 Prices and markets Vegetable prices are lowest when the majority of vegetables ripen. This period lasts from early summer until late autumn. Highest vegetable prices can be achieved in winter time. Cabbage prices are very high just before the first harvest in May. Producers of early vegetables can benefit from these better prices for cabbage in April-May. Tomato and cucumber prices are highest in May and June. Generally, early vegetable prices are 2-3 times higher than late vegetables. Key markets are in Pramot City and Pequeno Town.

3 History

Vegetable growing is a long-standing tradition in the Krain area as a result of the existence of irrigation facilities. Knowledge is passed on from parents to children. In other parts of the Pramot region it is a more recent activity and most people grow late vegetables. People here usually own their land. Households with little land and only limited access to irrigation water, grow transplants for sale. Due to a lack of funds, especially for the fuel needed to keep the hotbed temperature up, and a lack of knowledge, few farmers grow early vegetables.

4 Production method

4.1 Decision-making Vegetable production is always a family business with specific knowledge about sources of seeds and methods of speeding up plant development. At times, larger families cooperate to cover the investment costs of growing early vegetables.

4.2 Technical operations Early VegetablesThere are two harvests from the same plot of land – the first of early vegetables, mostly cabbage and tomatoes, and the second of potatoes, tomatoes, sweet peppers, cucumbers, etc. The second harvest is very often for family consumption.Early vegetable production involves:- Ploughing and applying fertilizer in autumn.- Greenhouse preparation. Plastic can last up to 2-3 years.- Hot bed and soil preparation- Hotbed sowing in January with own or purchased seeds- Plants are sprinkled with warm water- Weeding and maintaining hotbed with coal, wood, sheep dung etc.- Soil preparation in the greenhouse- Transplanting seedlings to the greenhouse two weeks after sowing. […etc.]

30

4.3 Inputs used Vegetable seeds can be selected from the previous year’s crop. Early vegetable producers usually purchase seeds from specialized suppliers in the capital, incurring transport costs. Imported seeds are preferred due to better quality. Plastic sheets and chemicals are bought in local markets. In winter and spring input prices are higher – vegetable producers try to purchase all inputs in the summer right after selling their harvested crops.

4.4 Labour force Required labour inputs for vegetable production are high. On 10 acres about 80 man-days are required for cabbage production […]

4.5 Financial resources Vegetable growing requires significant expenditure in January and February. For early vegetables working capital costs are about $500 per 10 acres; for later crops it is much smaller at about $60-70 for 10 acres.

4.6 Equipment Greenhouse (about $300), electrical pump ($50), a tank.

5 Crop disposal

5.1 Marketing Sale of early vegetables is mainly in Pramot city. Vegetables are sold per kg.

5.2 Processing Processing is mostly done in the Krain area. Only larger farmers sell to the canning factories there.

6 Financial calculations 1

6.1 Costs Costs include: ploughing, cultivation, seeds, fuel, plastic, electric power for watering, chemicals, transport costs and market expenses.

6.2 Revenue Average yield of early cabbage is 4.7 tons per hectare; revenue varies between $1,000 and $2,000. Average gross revenue from main crop vegetables is $300 -$500.

6.3 Seasonal variations Revenue is generated from April/May and continues until late autumn. If early vegetables are grown, the first revenue is in March/April.

1 These are preferably provided in detail in the form of gross margin calculations for different crops.

7 General prospects

7.1 Opportunities If the farmer has the knowledge and experience, early vegetables are a highly profitable business venture. In addition, family consumption can be satisfied from the second harvest.

7.2 Limitations Significant initial capital is required and a qualified labour force is needed.

Questions:

5. Have a look at AGLEND’s price sheet for inputs and crop sales. What are the trends? What impact do price fluctuations have on the profitability of agricultural production in general and for selected crops in particular?

6. Looking at the rainfall records, which regions are subject to high weather risks? Where has production been most affected by variations in rainfall?

31

Exercises:

7. Prepare a spreadsheet or table which summarises the key efficiency indicators for the agricultural production activities financed by your institution. In some countries agricultural colleges or universities or the planning department in the Ministry of Agriculture collect such information and you should try to contact them for copies of reports or publications that you can use.

8. Analyse the AGLEND sample enterprise profile for vegetable growing in the Pramot region. Which information is most important and which is less useful? What additional information would you like to include?

9. Develop an enterprise profile for one of the main crops produced in the area where you are located.

32

Chapter 4: The Agricultural Loan Cycle

Objective: to examine each step of the agricultural loan cycle in detail, including loan application procedures, field visits, loan appraisal, loan approval, disbursement and follow-up.

4.1 Steps in the Agricultural Loan Cycle

The relationship between a financial institution and its borrowers is governed by the fact that there is a time gap between the moment when a loan is disbursed and when it is fully repaid. Because of the particular nature of loan transactions, where money is advanced in exchange for the promise of future repayment, moral hazard is a major issue and must be controlled by reducing the asymmetric information between borrower and lender. This is done by collecting sufficient information on which to base loan decisions, as well as by adequately supervising and monitoring loan use to ensure that it is repaid in full and on time. These steps form part of the loan cycle which is illustrated in the following diagram.

Diagram 2 A typical loan cycle

i) Loan application

Potential borrowers fill out an application form, sometimes with the assistance of a loan officer. Ideally, completed loan applications are received by loan officers who can directly process them and decide on a date for an initial client visit, or alternatively advise the applicant why the application will not be accepted. Occasionally completing an application form may be combined with the initial client visit, but this precludes the implementation of a filtering mechanism that aims to keep costs under control.

This filtering or screening mechanism is used to ensure that only those farm households that have a fair chance of being accepted as clients are visited in the next step of the loan cycle. The screening consists of checking a number of key indicators that provide a quick pre-assessment of the potential creditworthiness of the customer. The indicators might include:

Farm size – there will be a minimum below which farming is not normally profitable; Enterprise efficiency factors e.g. yield levels of crops;

33

Loan application

On site client visit

Loan appraisal

Loan decisionLoan disbursement

Repayment

Monitoring and follow-up visits

A variety of income sources; A minimum level of available family labour and evidence of permanent residence.

ii) Client visit

The collection and cross-checking of data on-site is the key to determining the repayment capacity and the willingness of a potential client to meet his repayment obligations. Qualitative information about the client, his or her farm, other businesses and family is a basic requirement for assessing management capacities and the accuracy of the information supplied. Quantitative information forms the basis for a detailed analysis of the projected cash flow, as well as of the assets and liabilities of the farm household. This information will also allow the loan officer to determine whether any of the assets can be accepted as loan collateral.

iii) Loan appraisal

The information collected during the farm visit must be organised and assessed in order to arrive at a prudent loan decision. If available, computer software can support and substantially increase the efficiency of this process. With appropriate computer software, calculations are made automatically, balance sheets and cash flow projections are generated more quickly, consistency checks can be automated and sensitivity analyses can be carried out easily. In addition, basic information can be stored for further statistical analysis.

Loan officers prepare appraisal reports which are generally submitted to a Credit Committee for approval or rejection. Loan officers can be delegated some limited authority for approving (or rejecting) certain loans. An assessment of the client’s willingness to repay must be part of the loan officer's recommendation, for which he/she is fully accountable.

iv) Loan decision

Loan decisions are usually made by credit committees. The composition of the committee generally depends on the loan amount, with larger loans being decided by higher levels of management. Credit committees review the loan appraisal carried out by the loan officer, check for consistency with the institution’s loan procedures and policies and discuss critical aspects of the loan proposal. Usually, the loan officer who has carried out the loan appraisal attends the credit committee meeting to present the proposal and defend his/her recommendations. On some credit committees non-staff members may also be present. Involving local community leaders and key informants in the loan decision process can provide important insights and help ensure high quality lending decisions.

Credit committees form an important part of the risk management strategy of the lending institution. They carry out a vital internal control function by providing a second opinion on proposed loans.

v) Loan disbursement

After a decision has been made on a loan application, clients should be informed immediately of the outcome. Timely access to loans is a key factor for farmer clients, so the time between the decision and the disbursement of loan funds should be kept as short as possible. Loans can be disbursed in cash or in kind. Many financial institutions transfer at least part of the loan amount directly to suppliers by providing borrowers with a purchase order. This helps to prevent loan resources being spent on assets other than those agreed upon in the loan contract.

34

In particular, when large investments such as a tractor are being financed with a loan, it is probably advisable to pay the amount directly to the agreed supplier to avoid a large amount of money “burning” for too long in the hands of the borrower. Nevertheless, farmers should be consulted about the technical details of the equipment they wish to purchase and the reliability of selected suppliers.

vi) Loan monitoring and follow-up

Loan officers should exert strict supervision and control during the whole loan repayment period in order to make sure that repayments are made on time. Repayment discipline is essential in any prudent lending programme. Unfortunately, in many countries there has been a history of subsidised agricultural lending programmes with lax enforcement mechanisms for repayment. Where this has occurred, it is of particular importance for a new rural financial institution to communicate clearly to its clients that it will expect strict compliance with loan repayment conditions.

Monitoring of borrowers can be done in two ways: directly and indirectly. Direct monitoring takes place when loan officers visit clients on site after loan disbursement. For farming clients these visits should be scheduled for moments that are critical in agricultural production cycles, e.g. when crops are being planted and prior to harvesting. This will help the loan officer to identify at the earliest possible moment, potential problems that could cause delays in repayment or endanger the entire repayment. As continuous monitoring of borrowers is particularly costly in rural areas, the timing and sequencing of monitoring visits have to be carefully planned. Critical events such as unfavourable weather conditions or a severe outbreak of plant or animal diseases or pests should also affect monitoring plans.

Unlike direct and on-going monitoring of farm production activities, indirect loan monitoring is based on close observation of the timeliness of repayments and takes place only when a loan falls due. As soon as repayments are in arrears, the financial institution should implement an immediate standardised follow-up procedure with regard to the handling of late payments and loan arrears. Quick action, i.e. within days of a payment becoming overdue, is needed to make clear to the borrower that timely repayment has top priority for the financial institution and late payment will not be tolerated.

Whether direct or indirect monitoring is more appropriate depends on the loan product. Agricultural loans with a maturity of nine months or more, which are repaid in one instalment, for example when a crop is harvested, definitely require some direct monitoring. In contrast, agricultural loans for enterprises with more even revenue streams and repayment instalments set in line with the cash flow may be more efficiently monitored by indirect methods. Supervisory control visits may still be essential at critical moments such as the breeding season or during the outbreak of disease.

vii) Repayment

Complete repayment marks the end of the loan contract. At this point it is useful to put a rating on the client’s overall loan performance. This rating can be used for future loan decisions and may facilitate quicker and easier access to repeat loans. If repayment performance has been inadequate, future loan access should be restricted, if not barred.

Financial institutions can actively influence repayment performance in many ways. In agricultural lending, for example, the necessity for borrowers to travel long distances to make repayments at the office of a financial institution may reduce timely loan repayment and a more convenient system should be sought.

35

AGLEND use a number of techniques to facilitate borrower repayment:

1. Repayments are scheduled for days on which farmers usually come to town, for example on weekend market days.

2. The offices of AGLEND are located close to the farmers' market at the central bus stop so that they can be visited conveniently.

3. Office hours are very flexible and include evening and weekend services.

4. There is a mobile banking unit operating in some regions with low population density to increase accessibility by bringing banking services to the “back door”.

5. AGLEND has established good relationships with the major wholesale traders, marketing co-operatives, rice mills etc. in the different regions. Borrowers have the possibility of signing an agreement as part of their loan contract that allows the businesses buying the farmers’ crops to deduct repayments from the sales proceeds and to pay this directly to AGLEND.

Questions:

1. Which are the most important stages of the loan cycle for controlling moral hazard?

2. In what way would you expect the agricultural loan cycle to differ from other loan cycles, e.g. for consumption loans or loans for non-farm micro-enterprises?

3. How should a lending institution respond to late payments? What are the procedures followed in your own institution?

4.2 The Initial Screening of Loan Applicants

All financial institutions should have a mission statement that sets out the purpose and objectives of the business. An agricultural bank, for example, will target farmers and other related businesses operating in the agricultural sector. Many microfinance institutions target low income households and microenterprises as their core business. All financial institutions, however, will aim to make a success of their business, covering their costs and making sufficient profit to finance the expansion of their activities. To achieve this they will need to mobilize sufficient funds, lend out and recover those funds, and charge adequate interest rates, as well as seeking to improve efficiency all the time.

Lending money is risky - it might not be paid back. So everything possible must be done to recover loans through good client selection, careful loan appraisal, demanding loan collateral or guarantees as security, building client loyalty and so on. Using a mix of all these measures has meant that even

36

lending to micro entrepreneurs with very few assets is possible. It requires a significant initial investment in time, which is costly but less costly than making loans that cannot be repaid. The mix of economic activities and the complex inter-relationships so typical of farm households makes the collection of information on these clients and their businesses particularly time-consuming. A financial institution wishing to concentrate on this specific target clientele, therefore, should prepare a list of basic selection criteria that will immediately rule someone out, if they do not meet the basic criteria for getting a loan. In that way, staff time will not be wasted gathering detailed information on people who ultimately do not qualify for a loan.

AGLEND is an example of a financial institution that intends to target farmers who have some minimum commercial potential, which in their view will ensure loan repayment. So they have a list of criteria which takes 5 – 10 minutes to review and determines whether or not a loan applicant meets the basic eligibility criteria for receiving a loan. These criteria are highly context specific and any lending institution must carefully consider what criteria it will include in such a list, in order not to exclude potentially good clients who would help to fulfil the institution's mission statement.

These are the three core criteria used by AGLEND:

1. Previous loans from AGLEND.

AGLEND back office staff review whether the farmer interested in obtaining a loan already has a credit track record with AGLEND. This information is automatically checked in the institution’s computer system by entering the name and the ID number of the farmer. If the person has accumulated more than 30 days overdue on previous loans, access to future loans is denied and the loan application request is turned down immediately

2. Previous or current loans with other lending institutions.

In the absence of a credit reference bureau in the country, AGLEND and other rural financial institutions have agreed to circulate lists of their overdue borrowers that are updated on a monthly basis. Whenever a farmer contacts AGLEND and presents a loan request, these lists are checked to find out whether the person has unpaid loans or has a loan that is currently overdue. If people are listed as overdue borrowers, AGLEND immediately refuses their loan requests.

3. Borrower characteristics.

As a final step, AGLEND staff check whether the potential borrower complies with specified eligibility criteria. These criteria may be region or even branch specific. An example of a checklist used by AGLEND is shown on the following page.

37

1. Minimum age : Older than 21 years.

2. Location of the farm : Potential borrower from districts other than Magambe and Sobiri.

3. Crops eligible for lending :

What is the main crop or livestock produced? _________________________

Potential client produces crops other than: flowers, fruit trees.

4. Length of time that the farmer is carrying out his/her main production activity: He/she has a minimum track record of at least 2 years.

5. Farm property : The farmer owns his land and can provide adequate proof of it.

6. Farm size : The farmer has a minimum of 1.5 ha. in Caron and Pramot.

7. Mix of income sources :

When potatoes or coffee are the main crop, the farmer has a minimum of 3 different income sources.

When maize is the main crop, the farmer has a minimum of 4 different income sources, with at least one off-farm activity.

YES

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

NO

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

[ ]

This checklist shows that AGLEND wishes to screen out some client groups that it considers a high risk to serve. If any of the questions are answered with “no”, the screening process can be stopped and the client informed that he / she is not eligible.

The AGLEND loan officers carrying out these initial interviews may also develop a "gut-feeling" about a client’s probable creditworthiness. If there are indications that the loan applicant is hiding information or distorting facts, then they can stop the interview and tell the person he/she is not eligible.

In order to prevent the information being collected several times, e.g. during the screening interview, when the loan application is being completed, and during the field visit, the various forms used in the different steps of the loan cycle need to be inter-linked in a database. If this is done, all the information that is collected during the screening interview will automatically appear in the relevant sections of the loan application form.

Questions:

1. Which client groups are screened out by using the AGLEND checklist of borrower characteristics you have just looked at? Do you think it is a good policy to screen out these client groups? Is there an alternative?

2. What criteria would you set for screening agricultural loan applicants in your institution?

38

4.3 The Loan Application

Once the eligibility of a potential client has been established, they can proceed to submit a loan application. Financial institutions like AGLEND usually have application forms which need to be filled out by the staff together with the loan applicant. Loan application forms should contain much of the information that a loan officer needs to plan a visit to the applicant's farm and, at a later stage, carry out the loan appraisal.

Let us remind ourselves of the key factors for successful loan analysis: character, capacity, capital, collateral and conditions. All these factors matter, but for small farmers the first two – character and capacity to repay the loan – are the most important. Here is a list of questions that can help to provide information on each of these key factors, often known as the five “Cs”:

Character: Personal integrity of the farmer and his family

How is the farm managed? Is the family honest and trustworthy? What is the physical and mental health like of the person(s) running the farm? Has the family repaid bills and previous loans on time? Do they have any problems (alcohol and frivolous consumption, etc.)? Is the family open to innovation and do they have the skills to develop new business lines and

grasp growth opportunities?

Capacity: Ability of the farm household to repay the loan

What does the business plan indicate about income and profitability of the farm enterprise? Can the business generate enough cash to pay back the loan and accrued interest, including a

margin of security against uncertainties in the planned outcome? When can the loan be repaid? What are the family needs? What are the effects of seasonal fluctuations and production and price variations? How do the farm results compare to others with similar enterprises, operating under similar

conditions?

Capital: Money invested in the business

How much money and other assets are invested in the farm business? What is the family’s own contribution to the financial investment in the business?

Collateral: Backup security for the repayment of the loan

Are the personal guarantees of farm household members and any other third parties trustworthy? Are the assets of the business and the personal guarantees offered sufficient to cover the loan?

Conditions: Key economic conditions that impact on the ability to repay the loan

Is there an adequate and stable market to sustain the farm business enterprises? What are the general market trends in the agricultural sector? What are the specific production and price risks of the farm enterprises? Are the loan conditions (term, interest rate, repayment instalments) conducive to timely

repayment?

39

Now let us look at the details of the loan application form used by AGLEND and the information that they collect. There are six sections:

i. Personal and family data;

ii. Economic activities;

iii. Previous and current loans;

iv. Details of the proposed loan;

v. References;

vi. Declaration of the loan applicant.

i. Personal and family data

Name: ( ) Male ( ) Female ID Number

Civil Status: ( ) Married ( ) Single ( ) Widowed ( ) Divorced ( ) Other

Date of birth: / /

Home locality: Street and House N°Community:

Reference points:

For how long have you been living there: ____ years

DistrictProvince

Name of wife or husband:

ID Number

N° of household members: ______

N° of children: ______ Ages: / / / /

N° of other dependents: _____ Ages: / / / /

N° of household members who generate income: Regularly ______ Irregularly ______

40

In order to be able to visit the client, the home address needs to be documented. As street names are lacking in rural areas, AGLEND staff often add a little drawing on the back of the sheet and take note of reference points in order to be able to locate the loan applicant’s home.

It is important to know the civil status of the loan applicant and to find out more about his/her family background. So the loan applicant should provide information about the name and age of the spouse as well as about the time they have lived together. This will give an impression about the stability of the family and will also help to involve the partner in the loan process. AGLEND, for example, require spouses to co-sign loan contracts in order to ensure that they know about the loan obligation and feel responsible for it.

Knowledge about the family composition is important to ensure that the loan officer appreciates the need to analyse the monthly household budget requirements in-depth during the field visit. The number of children and other dependents, who do not generate income, clearly has an impact on household expenditure. Young children in particular lead to increased expenditure on education but older children may contribute significantly to household income and can help to diversify family income sources. In the example of the Crespo family, the sons work as construction workers in the town and generate additional family income.

ii. Economic activities

Main crop and livestock activities of the farm household:

Crops

1.________________

2.________________

3.________________

Years ofexperience________

________

________

Livestock

1.______________

2.______________

3.______________

Years ofexperience________

________

________

Other economic activities carried out by household members:

1._______________________________________

2._______________________________________

3._______________________________________

Regularly_______

_______

_______

Irregularly_______

_______

_______

N° of plots: _______ Size: / / / /

Location of plots:

Community:

Reference points:

DistrictProvince

An important and major part of a loan application form is the section on the economic activities carried out by the farm household. This information helps to construct a risk profile for the farm household, particularly when analysed together with the family structure and the farm land situation. It also allows the loan officer to obtain an insight into the variety of income sources and whether they provide a regular and reliable cash flow or not.

The years of experience with each economic activity gives an indication of the production skills of the farm household. The variety of crops under cultivation, for example, provides an indication of how well the farmer manages crop rotation systems and how well the crops complement each other in terms of seasonal labour requirements and expenditure and revenue streams.

If possible budgets for each main crop and livestock enterprise on the farm should be prepared and compared with averages for the region. This will give a better insight into the efficiency and productivity of the loan applicant and facilitate the construction of a cash flow budget for the whole household. An example of a crop budget worksheet for the cultivation of one hectare of

41

irrigated vegetables in Nigeria is provided on the following page. It contains considerable detail about the crop calendar and crop costs, both cash and imputed, but the physical units of both inputs and outputs and their respective unit prices have been omitted.

Because the location of farm plots is not necessarily close to the farmer’s home, it is important to get a clear and detailed description of where each plot is. These descriptions are particularly important for planning the field trip.

It is also important to establish the exact location of farm plots in order to assess the legal situation regarding land tenure and the quality of the land. A classification of the borrower in terms of legal title on the land that he cultivates and the possibility of land disputes should be constructed on the basis of this information. Also, later in the appraisal process estimations of crop yields can be cross-checked against the known quality of the cultivated land used by the farmer.

Finally, information about the number of plots that are cultivated together with their size and their location gives a further insight into the production strategy of the household and the associated cost-income structure and risk profile of the farm. For instance, small scattered plots limit machinery use and increase transport and management costs but the fact that plots are spread over a large area may help to lower weather risks.

Table 3 Crop Budget Worksheet – Nigeria Vegetables

Crops: Vegetables - Tomatoes, Peppers, Eggplant & Chile Pepper

Planting Season: Sept 2008 - March 2009

Area: 1 Hectare total (irrigated)

Activity Date Detail

Family Labour Work Days

Cash Costs (Naira)

Investment Costs (Naira)

Land Preparation Oct      

Tractor        

Animal Traction   Oxen (family time/days)    

Labour (Hired)     2,500  

Labour (Family)     5    

LAND CULTIVATION Nov      

Ploughing        

Harrowing   Oxen (family time/days)    

Labour (Hired)     2,500  

Labour (Family)     4    

INPUTS        

Equipment and Tools        

Sprayer        

Ox-drawn        

Water pump Sept     43,000

42

Tube well Sept     8,400

Pump Accessories Sept     1,200

Fertilizer        

Inorganic Nov10 (50 kg) bags at N1,200 12,000

 

Organic Nov Variable 2 7,300  

Herbicide Nov 4 litres at N722 2,888  

Insecticide Nov 5 litres at N1,140 5,700  

Fuel consumption-pumpNov-Dec 270 litres @ N55 14,850

 

Servicing of pumps Nov   2,000  

Planting Material        

Seed - 1(tomato) Dec 0.25 kg at N4,000/kg 1,000  

Seed - 2(large pepper) Dec 0.4 kg at N2,400/kg 960  

Seed - 3(garden egg) Dec 0.3 kg at N2,000/kg 600  

Seed - 4(hot pepper) Dec 0.4 kg at N2,400/kg 960  

PackagingJan-Mar

492 (25 kg) bags at N10/bag 2 4,920

 

BasketsJan-Mar

162 (25 kg) bskts at N10/bask 2 1,620

 

OPERATIONS        

Planting Dec    

Hired labour     3,125  

Family labour     3    

Fertilizer application Dec      

Hired labour     1,250  

Family labour     1    

Herbicide application        

Hired labour Dec   1,250  

Family labour        

Insecticide application Dec      

Hired labour     1,250  

Family labour        

IrrigatingNov-Dec

 5  

 

Weeding 1 Dec      

Hired labour     2,700  

Family labour     4    

43

Weeding 2 Jan      

Hired labour     2,700  

Family labour     4    

Harvesting 1 Feb      

Hired labour     4,500  

Family labour     8    

Bagging/PackagingFeb-Mar

  

 

Hired labour     1,000  

Family labour     6    

Storage        

Marketing Mar      

Family Labour     5    

Transportation     5,000  

Interest        

         

Other ______________        

___________________        

___________________        

         

TOTALS     51 82,573 52,600

COST SUMMARY:          

Cash Costs (CC) 82,573  

Opportunity Cost of Labour (LC) N1,250/day 63,750  

Fixed Cost (FC) (Assume only 1/3 of well & pump cost) 17,538  

Total Cost (TC)     163,861    

   

INCOME:  

Harvest Valueall crops 292,950  

Sales Incomeall crops 234,360  

Tomatoes Jan-Feb 55,080  

PeppersFeb-Mar 121,200  

EggplantFeb-Mar 7,200  

Chile Peppers Mar- 50,880  

44

Apr

Gross Income (GI)     234,360    

   

INDICATORS:  

Net Income (NI=GI-TC) 70,499  

% Net Income/ Total Costs (NI/TC) 43.0%  

Net Benefit (to family) (NB=-NI+LC) 134,249    

iii. Previous and current loans

Did you borrow in the past?

If yes, from whom did you borrow and for what purpose?

YES / / NO / / ____________________________________________________________________________________________________

Do you currently have an outstanding loan?

If yes, who is the person or institution you owe money to and what was the purpose of the loan?

YES / / NO / /

__________________________________________________

__________________________________________________

What was the original loan amount?

________________

How much is the remaining balance to repay?

________________

When do you expect the loan to be fully repaid?

____________________

You will remember that AGLEND endeavours to screen out borrowers with unpaid loans during the screening process before filling out the loan application. The information gathered here is designed to provide further insights into the credit history of the applicant.

Information about previous loans shows how familiar the loan applicant is with borrowing money. The name of the lending institution or person might provide an insight into the potential creditworthiness of the loan applicant. Previous loans from a highly subsidised credit programme might give warning of lax repayment morale and increased moral hazard risk.

Information on current loans is particularly interesting as it shows the current level of indebtedness and how much of the current income is already absorbed by servicing other loans.

45

iv. Details of the proposed loan

Amount applied for: ___________________ Term applied for: _________________

Activities/expenditure to be financed with the loan:

1.__________________________________________________________

2.__________________________________________________________

3.__________________________________________________________

Desired dates of disbursement:

_______________

Desired repayment plan: Monthly / /Bimonthly / /Quarterly / /

Irregular / /One final payment / /

Information about the applicant's preferences regarding the proposed loan gives AGLEND the opportunity to tailor the loan to real customer needs. The desired disbursement date, for example, is particularly important for agricultural production as a delay in the planting time of crops can result in significant income losses due to reduced crop yield. At the same time, the information provided in this section indicates how realistic the borrower is with regard to his financial needs, the required term to repay and the repayment schedule. It indicates how well a loan applicant knows and manages his cash-flow.

In addition, this section of the application can show whether borrowers are interested in a partnership with AGLEND that is frank and honest or whether they are distorting the facts. In many cases prospective borrowers overestimate the amount of loan they need and the required repayment period. However, once the loan applicant describes in more detail what he or she needs the loan for, AGLEND will be in a better position to assess the loan amount and term structure in the light of the actual needs.

v. References

Names of referees:_________________________________________

1._________________________________________

2._________________________________________

Address and telephone number:_________________________________________

_________________________________________

_________________________________________

Each loan applicant must name at least two people who will provide references and further information to AGLEND. If loan applicants refuse to provide this information, AGLEND turns down the loan application immediately, as it suggests a degree of moral hazard.

vi. Declaration

Once the loan application is filled out, AGLEND asks the loan applicants to sign two statements:

1. Self-Declaration: I hereby state that all the information that I provided is correct and true and provided in good faith. I am aware that any untrue information will result in the immediate refusal of this loan application and exclude me from accessing any future loans.

2. Authorization: I hereby authorise AGLEND to obtain information about previous and current loans from any financial institution, lending organisation or individual lender I have

46

borrowed from. I also authorise AGLEND to contact the persons indicated in the reference section of the application form and to use any other source of information that is deemed necessary to process this loan application.

These declarations show that AGLEND is very strict about customer transparency. Before visiting the loan applicant at his/her home or field, the loan officer to which the loan application is assigned, should carry out several cross-checks to review the information that has been provided. This can be considered a third screening mechanism that should prevent a costly field visit taking place to a loan applicant who shows little creditworthiness.

Questions:

3. Review the five information sections of the loan application form presented above and the list of questions that facilitate assessment of the five "Cs" of loan appraisal. Would you include any additional information at this stage?

4. Prepare a check list for an AGLEND loan officer to be used in conjunction with the loan application form in order to remind him which details to verify?

47

4.4 The Field Visit

A field visit is very important for gathering the data and information needed to analyse and process a loan application. So once the information provided by a farmer during the loan application process has been checked, the loan officer should schedule an on-site visit to the farm household.

The objective of this visit will be to obtain further information about:

the repayment capacity of the farm household and the factors that may have a negative impact on this (e.g. weak management skills of the farmer, a broken irrigation system, marketing problems, etc.);

the character of the borrower and his/her willingness to repay;

the availability of capital and collateral.

Let us look at what is involved in collecting this sort of information.

4.4.1 Repayment capacity

Small farm households have different characteristics from big enterprises or companies. They are family-based, carry out multiple economic activities and share income and expenditure. There is no clear distinction between the farm business and the household.

The following diagram illustrates how a typical small farm household has a common income and expenditure pot that is shared by all household members.

Figure 1

The repayment capacity of the farm household depends on whether there is enough cash available in the “family pot” to service the loan. Loan repayments are not made from specially earmarked funds, but are simply taken out of the cash reserves of the household. Thus the lender needs to figure out if there will be sufficient cash inflows to offset all the outflows, including loan repayment.

Analysing the cash flow of a farm household is a crucial task for a lender. Although the diversity of income-generating activities and expenditure patterns makes it somewhat complicated, it must be done. Some of the cash flows will be regular, while others will be irregular. For farmers most production-related cash flows are irregular, i.e. are seasonal in nature. Regular income may come from petty trade activities or off-farm employment, although even these may be affected by seasonal variations.

48

Livestock inputs

Income from crops

Income from

livestock

Income from wages

Income from other family

membersCrop inputs

Family expenses

Loan repayments

Analysing the current income and expenditure pattern of a farmer provides a picture of the cash fluctuation and risk profile of the farmer. We must, however, remember that a loan has to be paid back from future income. Therefore, income and expenditure must be projected into the future in order to determine whether the farmer will be able to repay a loan or not. Historic data about past cash-flows will not accurately reflect the real future repayment capacity of a prospective borrower . As we know, price volatility is particularly high in the agricultural sector. Weather conditions can change from one year to the next, as can international crop prices. It is therefore important to make a cash flow projection that is based on past experience and trends, but takes predictions about the future situation into account.

Loan officers from AGLEND are expected to collect information on the timing, frequency and probability of future income and expenditure flows during their farm visits. They must include seasonal and perennial crops, livestock with periodic sales of products (e.g. wool and meat) and those with daily sales (e.g. milk and eggs), temporary and permanent non-farm income generating activities, and all kinds of

regular and sporadic family expenditure.

In order to make realistic cash flow projections, the loan officers must obtain an insight into the production methods, farm management skills and external factors that may affect the farm household during the repayment period of the loan. These external factors can include the weather, as well as operational defects in the loan applicant’s irrigation, co-operative and marketing problems.

Let us accompany an AGLEND loan officer on one of his field visits to collect information on income and expenditure from the Crespo farm family who have applied for a $1,000 loan to purchase an additional plot of land for growing vegetables.

Good morning, Mrs. and Mr. Crespo. I am an AGLEND loan officer and I have come to review your loan application. How are you doing today? I see that you are already starting your seedbed preparation.

Welcome to Eagle’s Peak! We are very happy to see you here. It is so far away from the district town that nobody ever comes to visit us. The agricultural extension workers have stopped coming and the veterinary officer who used to vaccinate our ox and cow has stopped visiting us as well.

But you are right - we are currently preparing the seedbed for wheat production. These 2 hectares are very good land. My father took care of it and now I am running the farm, I take care of it.

Yes, the soil is very good here in this region. What yield per hectare do you get?

Well about 1,400 kg, when there is enough rain and we have enough money to buy fertilizer.

And what about bad years? How much do you produce in bad years?

Then the yield can go down to 900 kg per ha. I remember that happened in the year when the Church was burnt down in our village by the rebel group.

That is a long time back. I remember – I was still a child at that time. And since then, has it often happened?

49

No, no, maybe one or two times since then. I am taking care of my land and I know how to do it.

And how much wheat do you keep for your family and how much do you sell?

Well, we normally keep about 400 kg and the rest we sell.

That is a lot to keep. Do you have a big family? What do you use so much wheat for? You only need 200 kg as seeds for the next crop season!

Well, you know how difficult it is in this region. Today, the soldiers protect us. Tomorrow, they are gone and the rebels come to our homes.

Hmm... are there any other problems? I know that in this region there are a lot of difficulties with stem rust attacks.1

No, no, I use resistant varieties. And for the other pests, I always keep a stock of sprays. Here, have a look. These are my reserves.

Where do you sell your wheat after harvest?

There is a wholesale trader who collects the crop directly from the farm.

What prices did you get in previous years and what price do you expect this year?

Last year, I sold at $18 per 100 kg, but this year fewer farmers have grown wheat and I expect the trader will pay me at least 50 cents more than last year.

The price you got is one dollar more than the average price of last year. How do you explain that?

Well, I get my wheat graded at the local grain mill. So there is no need for the trader to do that for me. I prefer this … there is less possibility for him to cheat me.

When does he come to collect the wheat?

He normally comes in late May.

And when does he pay you?

In the past, he paid me cash when he came to collect the crop. However, because travelling in the region is not secure anymore, I opened an account in the Commerce Bank and he directly transfers the money into my account. Although this is more secure, I do not like it. The money always arrives one month later.

What inputs do you purchase to grow these two hectares of wheat?

...

As you can see from this interview, the loan officer is collecting data from Pedro about his wheat income and expenditure, but he is also getting additional information about production risks and farm management skills. In addition, answers are challenged and discussed with the loan applicant to obtain a realistic picture of the farmer’s production potential.

AGLEND provides its loan officers with forms for recording the information that they collect during a field visit. This is what they look like.

1 This is a wheat disease that causes red pustules with shrivelled grain.

50

1. INCOME FROM CROPS

Crop Area (ha)

Yield (kg/ha)

Total yield (kg)

Family Consumption

(kg)

Sales (kg)

Price /kg

Income ($)

Month

1 2 1x2=3 4 3-4=5 6 5x6=7

2. INCOME FROM LIVESTOCKSeasonal

Animals No. to be sold Income ($) Month

Total

RegularProducts Units/Day No. of

Days/MonthPrice/Unit ($) Monthly Income

($)1 2 3 1x2x3=4

Total

3. INCOME FROM NON-AGRICULTURAL ACTIVITIES

Activity Regular Monthly Income

Income per Month ($)

1 2 3 4 5 6 7 8 9 10 11 12

Total

4. CROP EXPENDITURE

Crop Inputs Quantity/ha.

Area (ha) Price/ Unit ($)

Expenses ($)

Month

1 2 3 1x2x3=4

51

Total

5. LIVESTOCK EXPENDITURE

Type of livestock

Inputs Units or Quantity

No. of head

Price/Unit or Quantity ($)

Expense ($)

Month

1 2 3 1x2x3=4

Total

6. OTHER BUSINESS EXPENSES (MACHINERY, HIRED LABOUR, etc.)

Economic Activity Item Expense ($) Month

Total

7. HOUSEHOLD EXPENDITURE

Monthly payments

Irregular payments

Comments

Food

Health

Education

Clothing

Rent

Water/Electricity/Telephone

Transport (bus, fuel)

Entertainment, festivities and religious activities

Other

SUB-TOTAL

Additional 10% for unforeseen expenses

TOTAL HOUSEHOLD EXPENSES

Payment of debts (monthly obligations)

During the field visit, the loan officer should keep the following in mind:

Delayed payments: Some applicants may purchase inputs on credit or sell their crops on credit. When asking about income and expenditure, it is important, therefore, to check when the cash

52

inflows and outflows actually occur. Current and proposed agreements should be discussed to provide a complete picture.

Underestimated household expenses. It is important to obtain information not only about regular consumption expenses, e.g. food, transport, fuel, etc. but also irregular expenditure on events such as weddings and other ceremonies, and other contingencies. Since family expenditure does tend to be underestimated, AGLEND includes an additional 10% for unforeseen items.

Unrecorded debts. Although information about existing loans is recorded on the loan application form, it is important to cross-check this information again during the field visit. In many cases, farm households have additional obligations that they do not consider to be loans as such. These can include, for example, pawning of personal goods or lease agreements for equipment or vehicles.

Importance of cross-checking. AGLEND loan officers always cross-check the data they collect by asking for support documentation such as receipts and invoices. Another cross-checking method is to include various family members in the interview. Suppliers and traders who have been mentioned by the loan applicant during the field visit can also be contacted to confirm information supplied by the farm household.

Loan officers should never take information supplied by applicants at face value only. They should always verify the information in the light of the risk profile and management capacity of the potential borrower and adjust the farm cash flow accordingly. They should also compare the information collected with averages from other farms in the region. If there are major deviations, the loan officer should re-check the information and in the end opt for more conservative figures.

There are a number of other risk-reducing management practices that can be assessed during the field visit in order to ensure that realistic projections of farm household income and expenditure are made.

Weather, pests and diseases: Agricultural production can always be hit by bad weather conditions or suffer damage from pests and diseases. Farmers try to mitigate these risks by adapting their farming systems, production methods and techniques to cope.

Many small farm households, for instance, have plots of land in different locations and this means that if one plot is hit by bad weather, other plots may not be affected and only a part of the crop yield will be lost. This technique, however, does increase management and transport costs.

Other techniques which reduce weather and pest incidence range from the simple use of seed-boxes to facilitate germination in cooler conditions and the purchase of disease-resistant crop varieties to the installation of suitable irrigation systems.

Rotation of crops. Appropriate crop rotation is important to maintain the soil fertility and structure, control diseases and pests and facilitate weed control. If this is not done properly, the quality of the soil may deteriorate and result in reduced crop yields and, hence, farm income.

Erosion control. Erosion results in a loss of land for production. To prevent erosion and maintain the area of fertile agricultural land, there are a number of different techniques that can be used. These range from reducing livestock grazing pressure to investment in terracing or planting trees and hedges.

53

Crop storage. Selling crop produce at the moment when prices are best is crucial but difficult for many small farmers. Only a few farm households have sufficient on-farm storage facilities and sufficient liquidity to postpone crop selling and keep harvested crops for a longer period, thus benefitting from higher farm-gate prices for crops later on during the season. Therefore, it is important to know whether farm loan applicants face marketing constraints and need to resolve these first.

The above list is merely illustrative and is not intended to be exhaustive at all. There might be many other aspects a loan officer should look at. If any of the factors give cause for concern, the loan officer should opt to adjust projections of farm income towards more conservative figures. In extreme cases, loan officers might even decide to reject a loan application following the field visit, if risks are considered to be too high and not manageable by the farmer.

Questions:

1. List in which ways a small farm household differs from a commercial farm specialised, for instance, in tobacco production.

2. How does the expenditure structure differ between seasonal crops (e.g. potatoes, vegetables) and perennial crops (e.g. coffee, sugar cane)?

3. Which income sources does the family Crespo have for repaying the loan they have requested from AGLEND? (The details can be found in Chapter 2.) Do you consider that family Crespo has a steady monthly cash revenue flow or is it rather seasonal and volatile?

4. Read the conversation between Pedro Crespo and the AGLEND loan officer again and identify the risks that Pedro Crespo faces in his farm production.

5. What type of information did the AGLEND loan officer cross-check during the interview with Pedro Crespo? Do you consider that Pedro Crespo answered correctly?

6. What is the revenue that the family Crespo get from wheat production?

7. Do you consider that the AGLEND loan officer has enough information to make a realistic projection of the revenue that the family Crespo get from wheat production? What additional questions would you ask in order to project the cash inflow from wheat production better?

8. Are you familiar with the risk mitigating techniques used by farmers who are clients of your financial institution? What are they?

54

4.4.2 Character and willingness to repay a loan

Field visits can also be used to gain a good insight into the character of the prospective borrower and to assess whether there are any risks of moral hazard. While farm income may be sufficient to repay a loan, a client may decide not to repay for a variety of reasons – for example, the existence of urgent family needs or a desire to improve the business or to repay other outstanding loans.

In normal commercial banking, the character assessment of a potential borrower is based on his/her ability to present an adequate business plan, the quality and reliability of the information given, and the credit history of the client with the financial institution. Character assessments of rural smallholders focus on the same issues, but differ in the methods that are used to obtain the required information and the key aspects to focus on.

AGLEND relies on the following sources of information:

i. The loan officer’s judgement: Throughout the field visit, the loan officer is considering whether the loan applicant seems to be a trustworthy and hard-working farmer or not. Is there evidence to suggest the farmer will do whatever possible to repay the loan, if he were to face unexpected problems?

Another key element in the assessment by AGLEND loan officers is the openness of the client in disclosing information and sharing it with the financial institution. Does the loan applicant voluntarily identify his assets? Does he readily provide receipts and other supporting documentation that loan the officer asks for?

ii. Reputation in the community: How do village community leaders view the loan applicant? What kind of reputation does s/he have? Is s/he seen as a reliable and trustworthy person, someone of whom the family and community are proud?

Finding reliable answers to these questions is a sensitive issue. AGLEND loan officers use a very indirect approach. They listen while having lunch at local restaurants or while travelling on the bus. They go to local events like football games or religious ceremonies and use these occasions to obtain more information about the villagers.

The only people that are interviewed directly are the referees that the potential borrowers have indicated in their loan applications. Loan officers usually decide on a case by case basis whether it is necessary to follow up on these references.

iii. Previous track record with the financial institution: The most reliable source of information for a lender is the client records held within the institution itself, i.e. bank current and/or savings account details or earlier loan records. Evidence that previous loans have been repaid in full and in a timely manner is the best indicator of repayment willingness. Generally this information is known from the time of the initial screening of the loan application.

AGLEND loan officers are urged to stop a field visit, if they have the feeling that the client is hiding important information or is not co-operative. However, there is a thin line between good and bad judgement. There is a difference between people who are just too shy to talk or have very little capacity to provide accurate figures and others who deliberately hide information or distort facts. Distinguishing between these two groups requires an experienced loan officer who has good communication skills and knows how to deal with different types of people.

55

Questions:

9. How can a loan officer build up the skills required to assess the character of a loan applicant?

10. Have another look at the interview with Pedro Crespo and identify any points that you think make him appear either a reliable or a less reliable client.

4.4.3. Capital and Loan Collateral

A balance sheet showing the assets and liabilities of the farm household is the key to understanding the capital position of a potential borrower. Of course, small farmers do not usually have written records or accounts, but it is not difficult to construct a balance sheet during the course of a field visit. It comprises two lists - one shows all the assets of the farm household and the other all the liabilities. The difference between the value of all the assets and the liabilities to people outside the family equals the net capital (also known as net worth or equity) of the farm household. This is a measure of the loan applicant’s ability to withstand and overcome possible adverse circumstances. Net capital is built up by ploughing profit back into the business.

Constructing a balance sheet is like taking a snap shot of the farm business at a particular moment. You can see what the family owns - land, buildings, machinery and equipment, household durables, livestock, growing crops, stocks of crops or inputs in store, goods purchased for resale and so on. Things that you cannot "see", but which are still part of the asset picture are the cash that the family has at home or saved in the bank, post office or co-operative, and the money that other people may owe the farm household (accounts receivable or debtors). The liabilities picture includes all the short, medium and long term debts that the farm household has - unpaid bills (accounts payable or creditors), leasing charges, informal and formal loans from other people or financial institutions. Most small farmers have no idea how much they may have invested in their business over the years, so working out the net capital can prove quite a surprise to them. It is certainly indicative of whether the farm enterprises have been profitable enough to allow them to save and reinvest.

In preparing a balance sheet we have to remember that small farm households are not able to clearly separate the household from the business enterprises. Therefore, a balance sheet that includes only farm-related assets and liabilities may seriously misrepresent the real economic and financial situation of the loan applicant. Some agricultural lenders only analyse the specific enterprise that is to be financed with a loan and the assets and liabilities related to that enterprise. Inclusion of household and other farm or non-farm assets and liabilities will require more of the loan officer’s time, but it will lead to more complete and reliable figures.

Moreover, including farm household assets that are not directly related to the loan purpose or the economic activity to be financed, gives a clear signal from the financial institution to the borrower that compliance with repayment obligations will be expected whatever the outcome of the financed activity, i.e. the borrower is accountable to the lender with all his/her assets, including household goods.

An important side effect of constructing a balance sheet is the ability to identify assets which the borrower can pledge to the lender as collateral for the loan.

56

AGLEND uses the following tables to record the capital situation of an applicant. The first lists the assets of a farm household. This form can be sub-divided to provide sub-totals for transfer into the balance sheet.

8. INVENTORY OF LAND, EQUIPMENT, LIVESTOCK, GROWING CROPS, STOCKS, HOUSEHOLD GOODS, etc.

Quantity Description Condition Value

Total Value

Financial information - debts, unpaid accounts, loans, cash in hand, etc. is entered directly into the balance sheet.

9. BALANCE SHEET

Assets Value Liabilities/Equity Value

Cash in Hand Accounts payable/short term

Cash in Bank or Co-operative Account Accounts payable/longer term

Inventory/Agricultural products Loans

Inventory/General trade products Leasing contract

Inventory/Other economic activities Household liabilities

Accounts receivable (Short term) Other liabilities

Accounts receivable (Long term) AGLEND Loan

Machinery, equipment and tools Total liabilities

Land and buildings

Household assets

Other assets Equity (Total assets – total liabilities)

Total assets Total liabilities including equity

It is important to remember that the above format is just an example and there are other ways to lay out a balance sheet, although the principles are always the same. The details from a small family farm may not require all the specifications indicated here and different groupings and labels can be used.

Being certain about the accuracy of the information in a balance sheet is not an easy task for a loan officer. AGLEND’s officers have identified the following problems in setting up a reliable balance sheet:

57

Asset ownership: Farm assets are often located or stored in different places, so it is quite a challenge to identify and record everything and to make sure that these assets are actually owned by the farm household. For example, if a farmer claims that cattle grazing on community grassland belong to him, this statement must be reconfirmed. Farmers may claim that they own a machine that is currently loaned or rented out to someone else, so that it cannot be shown to the loan officer. This has to be carefully checked in order to obtain reliable figures.

Asset valuation: A particular challenge is determining the commercial value of the existing farm assets. It is important not to just take down the historical purchase price of an item or simply accept selling prices suggested by the farmer. Loan officers need to develop a good understanding of valuation principles, particularly for machinery. The AGLEND inventory form requires the loan officer to assess the condition of equipment and ideally machinery should be seen in use to evaluate it properly. Items which need repair or maintenance in order to function properly should be limited to about 20% of its sale value.

Raw materials should be valued at purchase price after first checking their current condition. The same procedure applies to stored agricultural produce. Loan officers need to check with their own eyes the quality of the stocks and the adequacy of the storage facilities. A good knowledge of current prices in the local agricultural market is vital for the valuation of these items. Growing crops are usually valued at the cost of inputs used to date.

Cash and savings: Cash in hand must be seen by the loan officer to be included in the balance sheet. By the same token, only those savings that are verified in an account passbook should be included. This is a conservative approach as many loan applicants might still have a “reserve for a rainy day” that they do not want to disclose to the loan officer. However, it is better to underestimate the available short-term liquidity than to overestimate it.

Accounts receivable and payable: Though many farm households might sell their produce on credit or purchase inputs on credit, they might not appreciate that these future cash transactions should be included in the balance sheet. Therefore, it is very important to ask about these transactions.

Informal loans: Liabilities to family, friends, neighbours and informal moneylenders are difficult to trace and require experience, good interview techniques, and a lot of asking around in the community where the loan applicant resides.

Pawn loans: In some countries, pawning of gold or jewellery is widespread, particularly in rural areas. However, as the repayment of these loans may be several months ahead and not very certain, many farmers forget to mention them. Loan officers have to ask specifically about them.

Successful field visits require many skills – loan officers must be alert, sensitive, observant, knowledgeable and able to quickly check figures in their heads. Supportive documentation should always be asked for and cross-checked whenever available (e.g. receipts, ownership documents, statements) and the process should not be hurried. It is too costly to go back to ask about things that have been forgotten. The greatest investment of time will be with first time borrowers. Working with existing clients is quicker, because much of the essential information is already known.

Exercise:

1. It is time to get out into the field and practice! Can you produce a balance sheet for a typical farm household in your area?

58

4.5 Loan Appraisal

The key elements of loan appraisal are a careful assessment of the loan applicant's:

repayment capacity;

character or personal creditworthiness;

capital and collateral situation.

4.5.1 Repayment capacity

All the information that has been collected on farm household income and expenditure during the field visit is now consolidated in a cash flow projection. The exact period covered by the cash flow projection depends on the anticipated loan term. For agricultural production loans, monthly projections over one year are common, because they encompass the typical growing period of most annual crops. Projections beyond 12 months are needed for perennial crops which often require a long establishment and gestation period. There are more uncertainties in this situation and it is recommended that cash-flow projections associated with medium and long-term loans are revised annually.

A typical layout for a cash flow projection is shown on the next page. The procedures are quite simple – you have to write down all the money that is coming in each month (cash inflows) and all the money that is going out each month (cash outflows) and calculate the difference between them. This is called the monthly balance or net cash flow and it may be positive or negative. Positive balances can be regarded as net income or surpluses which can be saved, provided all the household expenses, including contingencies, have been taken into account. It is the cumulative net cash flow which can be used to repay any proposed loan.

Expenditure information can be grouped together by economic activity, e.g. types of crops grown, or by product categories, e.g. fertilisers, pesticides, machinery costs. The example on the next page is grouped by economic activity. Household expenses are always in a separate grouping. Cash inflows are generally grouped according to economic activities. All the information that was collected during the field visit regarding weather impact, market conditions and trends, expected purchase and selling prices, management skills, risk reduction measures, etc. should be taken into account when deciding on which figures to put in the cash flow projection. As a general rule, it is best to use conservative estimates, especially when new production methods or new economic activities are being introduced.

Loan officers should be fully aware that the quality of their loan portfolio and the health of their financial institution will depend on the quality of their loan appraisals. Therefore these should be based on reliable cash-flow projections and accurate assessment of the repayment capacity of loan applicants. This depends on collecting reliable information during field visits and, if possible the use of electronic spreadsheets which ensure fast and accurate calculations. Spreadsheets also make it easier to undertake sensitivity analysis which involves re-calculating the outcome after changing critical assumptions or variables.

An example spreadsheet showing how it has been used to make a cash flow projection for a farm household in Nigeria cultivating one hectare of vegetables is shown on the following pages. The figures for the vegetable crops are based on the crop budget illustrated on pages 44-46. The family does have other income generating activities but data from those have been excluded. The spreadsheet has been set up to facilitate loan planning.

59

Name: CASH FLOW PROJECTION Year:CASH INFLOWS (Money coming in) Month: Month: Month: Month: Month: Month: Month: Month: Month: Month: Month: Month:

Sales:Crop 1Crop 2Crop 3Livestock activity 1Livestock activity 2Sales, other farm enterprises:Sales, non-farm enterprises:Other farm household sales:Wages:Other sources of revenue:TOTAL (A)CASH OUTFLOWS (Money going out)Expenditure:Agricultural inputs, Crop 1Agricultural inputs, Crop 2Agricultural inputs, Crop 3Livestock inputs, activity 1Livestock inputs, activity 2Livestock purchases:Hired labour Non-farm enterprisesEquipmentHousehold consumptionOther expenditureAccounts payableOther debt paymentsTOTAL (B)MONTHLY NET CASH FLOW (A – B)CUMULATIVE NET CASH FLOWSection for Loan Officer useLoan repayment scheduleRevised MONTHLY NET CASH FLOWRevised CUMULATIVE NET CASH FLOW

An example spreadsheet structured to enable loan planning based on cash flow

CASH FLOW PROJECTION (12 MONTHS) -- Nigeria Mixed Vegetable Production

 Month 1

Month 2

Month 3

Month 4

Month 5

Month 6

Month 7

Month 8

Month 9

Month 10

Month 11

Month 12 Total

  Sept Oct Nov Dec Jan FebMarc

h Apr May June July Aug  Sales Income                          

Tomatoes        27,54

027,54

0            55,08

0

Peppers          60,60

060,60

0          121,2

00Eggplant             3,600 3,600          

Chile Peppers            25,44

025,44

0        50,88

0Animals                         0Non-agric. Income                         0

Total Income 0 0 0 027,54

088,14

089,64

029,04

0 0 0 0 0234,3

60   Production/Expenses                          

Vegetable Prod. Costs   2,500 39,81323,22

0 3,27010,77

0 3,000          82,57

3Animals                         0 Non-agric. Activities                         0Interest Payments *   0 0 0 0 0 0 0 0 0 0 0 0

Equipment52,60

0                      52,60

0Total Production Expenses & Investments

52,600 2,500 39,813

23,220 3,270

10,770 3,000 0 0 0 0 0

135,173

     

Net Cash Income

-52,6

00

-2,50

0

-39,81

3

-23,22

024,27

077,37

086,6

4029,0

40 0 0 0 099,18

7

Family Expenses   6,25010,625

.013,12

5.07,500.

019,37

5.06,875

.0          63,75

0

Repay. Existing Loans                         061

ObligationsNet Loan Repayment Capacity

-52,6

00

-8,75

0

-50,43

8

-36,34

516,77

057,99

579,7

6529,0

40 0 0 0 035,43

7

62

LOAN PLANNERNew Loans                         0Loan Principal Payments                         0

Net Cash Flow

-52,6

00

-8,75

0

-50,43

8

-36,34

516,77

057,99

579,7

6529,0

40 0 0 0 0  

Accum. Cash Flow

-52,6

00

-61,3

50

-111,7

88

-148,1

33

-131,3

63

-73,36

86,39

735,4

3735,4

3735,4

3735,4

3735,43

7  Loan Payments (Principle + Interest) 0 0 0 0 0 0 0 0 0 0 0 0 0

                         Loan Balance 0 0 0 0 0 0 0 0 0 0 0 0   * Assume monthly interest payments** Note in this example only family expenses relating to the vegetable production are included in order to show the cash flow of the vegetable production by itself. For discussion and analysis, please recognize the importance of also including non-vegetable income (ie. all household income) and all household expenses in the loan planning.

63

Once a cash flow projection has been prepared for all the economic activities, farm and non-farm, of all the household members and all the family expenses have been incorporated, it needs to be assessed in relation to the proposed loan. The most commonly used indicators for doing this are:

the accumulated repayment capacity, and

the net cash flow after loan repayment or the "free net cash flow"

The accumulated repayment capacity indicator is calculated by adding up all the monthly balances over the envisaged loan period and comparing this figure to the total amount to be repaid, i.e. both loan principal and interest.

CASH INFLOWS Month: Month: Month: Month: Month: Month: Month:

Sales of:Crops

Livestock, animals

Livestock, products

Accounts receivable: Wages:Other sources of revenue:TOTAL (A)CASH OUTFLOWSCrop inputs:

Livestock inputs:

Livestock purchases:

Equipment and machineryOther fixed assetsHousehold expenditureOther expenditureAccounts payableOther debt paymentsTOTAL (B)MONTHLY NET CASH FLOW (A – B)CUMULATIVE NET CASH FLOW C

Section for Loan Officer useLoan repayment schedule DRevised MONTHLY NCFRevised CUMULATIVE NCF

Cumulative Net Cash Flow over Loan Period (C)

Loan Principal Repayment plus Interest (D)

© FAO / RFLC 64

> 2

Since the cumulative net cash flow needs to be larger than the total repayment obligation which the applicant would have towards the lender, this indicator must be at least above 1. However, since it is advisable to have a sufficient security cushion for unforeseen events, it is recommended that the ratio should be at least 2:1. Needless to say, the higher the benchmark is set for this ratio, the more conservative is the risk-taking behaviour of the lender.

AGLEND applies an accumulated repayment capacity indicator of 2, which means that the borrower would be able to pay back twice the loan amount (plus interest) with the accumulated net cash flow generated during the loan period.

Let us look at how the Crespo family would perform using this indicator in relation to a proposed loan of $1,000 repayable in one instalment at the end of a year.

Loan Application Net Cash Flow before Loan Repayment ($)

$ First Quarter 600

Loan amount 1,000 Second Quarter 1,050

Interest charged at Third Quarter 600

2% flat per month 240 Fourth Quarter 550

TOTAL 1,240 TOTAL for 12 months 2,800

Accumulated Repayment Capacity = $2,800 / $1,240 USD = 2.26

Clearly, the net cash flow of the Crespo family would allow them to repay the total loan amount of $1,000 plus interest of $240 more than two times. In fact, the figure is 0.26 points higher than the required benchmark of 2. These ratios may also be expressed as percentages, e.g. the benchmark is 200% and the accumulated repayment capacity of the Crespo family is 226%.

As you can see, the accumulated repayment capacity is a very simple and straightforward indicator, which can be calculated quickly once a cash flow projection has been prepared. It has, however, one major shortcoming: if repayment instalments are spread throughout the year, it does not show whether the applicant will be able to repay each individual instalment on time.

Due to seasonal variations in agricultural production activities, the net cash flow of a farm household generally varies from month to month. Between crop planting and harvesting, there is always a period of reduced cash availability that has to be bridged by the farm household. If a lender requires loan repayments during this period, it will stretch the borrower’s scarce cash resources. AGLEND’s current loan product has to be repaid in equal monthly instalments. Consequently, their clients have to ensure that each month’s net cash flow is sufficiently high to cover the monthly repayments of loan principal and interest.

This is where the second indicator, net cash flow after loan repayment or the "free net cash flow" indicator can be useful. It can be calculated monthly or at the end of the loan period, if loan repayment is due in one final lump sum.

65

MONTHLY NET CASH FLOW (A – B)CUMULATIVE NET CASH FLOWSection for Loan Officer useLoan repayment plan X X X X X Y

Revised MONTHLY NCF

Revised CUMULATIVE NCF

Monthly calculation = One repayment calculation =X Y

X represents monthly repayment instalments and Y represents repayment in one lump sum.

The free net cash flow indicator must be positive. A figure greater than 0.5 indicates that after all consumption needs, economic activity-related expenses and loan repayments have been met, the applicant would still have cash left that is equal to more than 50% of the loan instalment, including interest. The existence of such a security cushion during the entire loan period ensures the borrower will have sufficient resources to cover unforeseen expenditure, expenditure that has turned out to be higher than initially planned or reduced income. The assumption is that the security cushion will decrease loan default risk.

AGLEND requires the "free net cash flow" ratio to be above 0.5.

Let us look again at the Crespo family. Will they have sufficient free net cash flow after loan repayment to pass this hurdle in AGLEND’s loan assessment? Here is a summary of the figures from their cash flow projection.

Months Monthly Net Cash Flow

(A)

AGLEND Loan Repayment Instalments

(B)

Net Cash Flow after

Repayment A-B=C

Free NetCash Flow

C / B

1 165 103.33 61.67 0.59

2 220 103.33 116.67 1.12

3 215 103.33 111.67 1.08

4 200 103.33 96.67 0.93

5 250 103.33 146.67 1.41

6 600 103.33 496.67 4.80

7 200 103.33 96.67 0.93

8 185 103.33 81.67 0.79

9 215 103.33 111.67 1.08

10 160 103.33 56.67 0.54

11 190 103.33 86.67 0.83

12 200 103.33 96.67 0.93

66

Months Monthly Net Cash Flow

(A)

AGLEND Loan Repayment Instalments

(B)

Net Cash Flow after

Repayment A-B=C

Free NetCash Flow

C / B

You can see that in each month the free net cash flow is always greater than 0.5 or 50% of the monthly repayment instalment. It suggests that the Crespo family will have sufficient reserves left after complying with their loan repayment obligations to cope with unexpected events.

However, the accumulated repayment capacity is more important than monthly free net cash flow. As many farm households have a highly variable pattern of income and expenditure, loan products which require equal loan repayment instalments are not very suitable. Ideally, a more flexible repayment schedule based on monthly net cash flows should be used. A number of variations are possible:

Monthly interest payments combined with repayment of the loan principal in a lump-sum at the end;

Various irregular payments of interest and loan principal; The entire loan principal plus interest paid at loan maturity.

In these instances the monthly free net cash-flow will not be of much help. However, the calculation of the accumulated repayment capacity ratio will be critical to decide whether a loan should be approved or not. In addition, the free net cash-flow should be positive in all those months where instalment payments are planned.

Sensitivity analysis

In order to find out how cash flow might be affected by adverse factors, the loan appraisal should include a sensitivity analysis. The objective of this is to find out whether adverse circumstances would undermine the repayment capacity of the borrower to such a degree that loan repayment would be at risk. Factors to be considered in a sensitivity analysis of cash-flow projections might include:

Reduced crop yields due to bad weather conditions, diseases or pests;

Delays in payments owed to the farmer, e.g. for crops sold after harvest;

Lower than expected sale prices;

Higher input costs;

Additional labour costs, e.g. replacing a sick family member with hired labour.

Cash flow indicators of borrower repayment capacity should, therefore, always be carefully assessed with regard to their sensitivity to these types of changes. In this way, a specific risk profile can be constructed for the loan under consideration. Financial institutions should have in place policies which clearly state what level of tolerance with regard to net cash flow indicators is acceptable. For example, it could be stated that the monthly free net cash flow should not fall below zero more than three times a year, even in worst case scenarios.

It is important not to take too simplistic an approach to sensitivity analysis, e.g. by just recalculating numbers in a mechanical fashion. This is a particular temptation when electronic

67

spreadsheets are being used. We have seen earlier how farmers use different risk mitigation techniques to keep their vulnerability to risks at a reasonable level. When analysing the sensitivity of cash-flow projections to adverse conditions, these risk mitigating techniques should be taken into account as part of the risk profile for farm households concerned. Here are some examples: Diversification of income sources: Prudent farmers respond to farm income insecurity by

diversifying, where possible, the number and types of their income sources. Potential losses in one agricultural activity can then be offset by income from other agricultural or non-agricultural income-generating activities.

Many small farm households also generate income from off-farm activities such as seasonal work for other farms or agri-business enterprises, handicraft production, small trading or service activities, tourism or construction work. Some family members may carry out exclusively non-agricultural activities such as running a small shop or working for a salary in a nearby town. Some relatives may work abroad and send regular payments (remittances) back to the family.

In a crisis scenario many farmers will try to diversify their sources of income quickly, often by selling their labour to others.

Liquidation of assets: Many farm households keep savings in-kind, commonly in the form of small livestock or jewels. Confronted with an emergency situation, they can sell these assets to obtain funds.

Social safety networks. In many countries, informal safety networks exist within extended families or clans. If a person has a problem, family support is mobilised. In many cases however, this support structure is not without cost. Farm households must constantly contribute to maintain their position in it. When festivities take place, cash contributions from all invitees are expected.

In the Andean region, for instance, it is very common for family members to lend money without interest to their relatives, and repayment conditions are very flexible. However, if a person has lent to others, he obtains the right to gain immediate access to money when he needs it. Understanding how these informal networks work is helpful in determining whether a borrower is likely to be able to mobilise money at short notice from within the extended family to meet repayment obligations.

Questions:

1. Let us assume that the crop trader who purchases the wheat from the Crespo family is sometimes late with his payments. If he does not pay Pedro the predicted $450 for his wheat in month 6 (June) but in month 7 (July) instead, work out what impact this will have on the projected cash flow on page 66.

Revised free net cash flow ratio for June:Revised free net cash flow ratio for July:

Would you still recommend the loan is approved?

2. Pedro Crespo's daughter is getting married in May. He has already set aside $25 for the festivities. However, he is not sure whether this is enough. He heard that his daughter’s future husband remarked about the low amount. Pedro is unsure whether he should plan to spend an

68

additional $95. Since the AGLEND loan officer has made a detailed study of his cash-flow, he decides to ask his advice. What would you advise him to do? Do you think he can take $95 from his May (month 5) net cash flow?

69

4.5.2 Character assessment

The information obtained during the field visit, the results of the careful review of client history and the cross-checking with other information sources must now be combined in a final assessment of the personal creditworthiness of the loan applicant. A structured way of carrying out such a character assessment is the introduction of a simple rating system like the one used in AGLEND.

Excellent Fairly Good

Sub-Optimal

Bad

a) Disclosure of required information

b) Reputation within the community

c) Credit history with AGLEND and other lending institutions

a. Disclosure of required information: Clients should demonstrate that they are interested in establishing a relationship of mutual trust with AGLEND. A proxy for this is the client’s willingness to share available accounts, receipts and other documents with the loan officer as well as show him all available assets and even cash.

b. Reputation within the community: AGLEND loan officers inquire whether the potential borrower has a reputation of being honest and hard-working. A proxy for “word of mouth” information regarding the reputation of the applicant within the community is whether s/he has held public positions or has played a role at public events. For example, if the loan applicant has been elected as treasurer of the local football team, this tells us that the villagers trust him.

c. Credit history: A borrower who has never failed in previous loan repayments is less likely to default in the future, as opposed to somebody who has had repayment problems in the past. Consequently, the credit history of a loan applicant discloses important information about his loan discipline and repayment culture.

In the case of AGLEND, an evaluation of any of these character assessment criteria as “bad” will result in the immediate rejection of the loan request. There will be no further appraisal and the case is not presented to the credit committee.

If any of the three assessment criteria receives a “sub-optimal” evaluation, the loan officers will need to detail in writing and during the credit committee meeting as to why the loan should still be considered.

AGLEND supervisors regularly check during credit committee meetings and on-site with the loan applicants to ensure that this rating is not done in a mechanical way.

70

4.5.3 Capital

The next step in the loan appraisal is an analysis of the balance sheet to assess the applicant's capital situation. It is not as critical as the cash flow analysis, but we can gain some useful insights into a business, even that of a small farmer, from a balance sheet.

Here is a reminder of the balance sheet layout, followed by examples of things you should look out for:

Assets Value Liabilities/Equity Value

Cash in Hand 1 Accounts payable/short term 7

Cash in Bank or Co-operative Account 2 Accounts payable/longer term 7

Inventory/Agricultural 3 Loans

Inventory/General trade Leasing contract

Inventory/Other business activities Household liabilities

Accounts receivable/Short term 4 Other liabilities

Accounts receivable/Longer term 4 AGLEND Loan

Machinery and equipment 5 Total liabilities 8 (B)

Household assets

Land and buildings 5

Other assets Equity 9 (C) = (A - B)

Total assets 6 (A) Total liabilities plus equity

1 Large amounts of cash - especially outside harvest time – should trigger a closer investigation as to why this available cash has not been invested and where it is coming from. Conversely, low amounts of cash immediately after harvest, combined with a lack of visible investment in household goods or farm assets will also signal a potential problem. A close analysis should then be carried out by the loan officer.

2 The existence of savings in a deposit account indicates that the loan applicant does not consume or invest all his/her income, but sets a certain amount aside. On the one hand, this could be a sign

71

Questions:

3. Review the criteria that AGLEND uses for assessing the character of loan applicants. Would you change or add anything?

1. Which criteria would you use to make a distinction between an excellent, fairly good and sub-optimal character assessment? Can you provide concrete examples to illustrate the difference?

of thriftiness and a wish to create a safety reserve for rainy days. On the other hand, it could mean that there are few investment opportunities and the farmer has a lack of entrepreneurial initiative. It is therefore important to scrutinise the reasons for savings.

3 The value of the existing agricultural stocks – inputs or harvested produce – gives an insight into how successful the farm business is. Very low stocks prior to the start of the production season can indicate the farm’s dependence on external funds to keep it running. In contrast, large quantities of stored crops show that the farmer is able to postpone selling crops immediately after harvest and can wait until prices are more favourable.

4 Accounts receivable (debtors) is an important figure, as they can cause severe liquidity problems if the money due is not paid to the farmer on the due date.

5 The composition of the farm’s fixed assets reveals key information about the production methods used. In addition, the figures indicate how new equipment is and how well the farmer is able to carry out maintenance.

6 The value of total assets indicates how successful the household has been in its operations and how much wealth has been accumulated over the years. The level and composition of the assets can be compared with similar farm households in the region, i.e. those with similar farming systems and production methods.

7 The existence of accounts payable (creditors) indicates that the loan applicant already has obligations with other creditors. This means that there will be cash outflows in the future which must be taken into account in the loan appraisal.

8 Level of indebtedness: expressing liabilities as a percentage of total assets indicates what proportion of the farm’s assets have been financed through borrowing.

Total Liabilities (B)

Total Assets (A)A low ratio, e.g. 20 or 30 % indicates that a farm household was able to purchase and accumulate most of its assets with its own resources. In many countries over-indebtedness is a serious problem for micro-enterprises and farm households. Therefore, it is recommended that agricultural lending institutions check the level of indebtedness before and after a proposed loan as part of the loan appraisal. It may be wise to set a maximum level of indebtedness of e.g. 50%.

9 Equity: the farmer’s own capital or equity expressed as a percentage of total assets is the mirror image of the level of indebtedness.

Equity (C)

Total Assets (A)

Obviously this ratio gives the same message as the level of indebtedness but instead of a maximum, a minimum level is required, e.g. 50%.

72

x 100

x 100

AGLEND includes the loan amount that has been requested, including interest that will be accrued over the proposed loan period, in the total liabilities when calculating the level of indebtedness. On the asset side, however, AGLEND does not include the planned investment.

This conservative approach enables the loan officers to appraise loan applications on the assumption that the production activity fails or that the loan funds are either partly or completely diverted for household consumption purposes.

The benchmark set by AGLEND of an indebtedness ratio below 50% requires that more than half of the total assets should be financed by the applicant's own funds and less than half with credit. Selecting an appropriate level may simply be an educated guess, particularly during the initial phase of an agricultural lending programme. However, the level set should be compared in the course of time with actual loan performance. This will enable the benchmark to be amended so that it reflects the actual loan default risk better.

While including the requested loan in the calculation of the indebtedness ratio ensures that the loan analysis concentrates on the situation after the loan has been taken, the conservative approach of not including the assets to be financed by the loan may not be adopted by every agricultural lender. Thus it is important to state clearly whether the financed assets are included or not – and if they are included, how they have been valued. One option may be to include the loan on both the liability and the asset side, i.e. increasing both by the same amount. Another option may be to deduct a security cushion from the loan amount on the asset side in order to cater for loss of value or potential deviation of funds. No matter which option is chosen, it is important to set and test benchmarks which can reduce loan default risk resulting from the over-indebtedness of the client.

Let us look again at the balance sheet that the AGLEND loan officer constructed for the family Crespo.

ASSETS ($) LIABILITIES & EQUITY ($)

Cash on hand 5 Accounts payable 100

Savings in co-operative 5 AGLEND loan 1,000

Agricultural stocks 765

Accounts receivable 1,425

Fixed assets (machinery)

250

Household goods 150 Equity 1,500

TOTAL 2,600 TOTAL 2,600

What is the indebtedness ratio?

73

It is: $1,100 which equals 42.3%

$2,600

So the Crespo family meet the AGLEND benchmark of a maximum indebtedness ratio of 50%, if the loan to buy additional land is approved.

4.5.4 Collateral

Another purpose of examining the asset and liability structure of a loan applicant is to identify appropriate loan collateral. However, compared with assessing the loan repayment capacity of a potential borrower which is the essence of sound agricultural lending, taking collateral is a second priority.

AGLEND views loan collateral primarily as an incentive for the borrower to repay on time and not risk losing precious assets. They have defined the following conditions for any asset that they will accept as collateral:

1. Importance to the borrower: The asset must be of high personal value to the borrower. He/she must be seriously affected if the asset were to be taken away by AGLEND.

2. Value: The asset must have a value that is sufficient to cover the loan amount, interest for the entire loan term and possible penalty charges. The minimum value of the asset(s) must be at least 1.35 of the total loan amount.

3. Marketability. The asset must be easy to sell. Transfer of property rights should be able to take place at little cost and with few formalities. In addition, the asset must be free from any liability obligations to third parties.

According to these three factors, the economic value of the collateral is only one side of the story. It is even more important that the borrower feels strongly attached to the asset(s) and losing it would cause him/her considerable psychological damage.

Against this background, AGLEND accepts a wide range of collateral, including household goods like TV sets, bicycles, personal guarantors, livestock and land. In the majority of cases, a combination of collateral items is used.

In order to avoid lengthy legal procedures, AGLEND asks the borrowers to sign a document agreeing to hand over ownership of certain assets to AGLEND at the moment of signing the loan contract. With this document, AGLEND becomes the owner of these assets during the entire loan period. AGLEND allows the borrower to continue using these assets but is allowed to remove them at any time, if the loan becomes overdue. This allows AGLEND to immediately enforce loan repayment without a court decision.

74

x 100

Questions:

5. Does a high amount of cash in a farm household automatically indicate a good borrower? What analysis should be carried out to obtain a clearer picture?

6. What are the pros and cons of different ways of calculating the indebtedness ratio? Which method would you use in your calculations?

7. What is the collateral policy of your financial institution? What could be improved in AGLEND and in your institution with regard to loan collateral policy and management?

8. The balance sheet of the Crespo family farm shows a high figure for accounts receivable because they sell the bulk of their produce to buyers on credit. Do you consider this too risky and what would you advise them to do about it?

9. If one buyer who owes Pedro money for a fifth of his total sales fails to pay at all, what impact would this have on the balance sheet and the indebtedness ratio?

4.5.5 Environmental analysis

Rural investments play a vital role in the correct management and use of scarce, non-durable natural resources. It is therefore essential to sensitise rural financial institutions to environmental issues as, in their role of providing lending resources for rural/agricultural investments, they have a special responsibility to support only those investments that help to maintain the sustainability of available natural resources and which do not cause any adverse environmental impact. Unchecked land clearance and deforestation, for instance, are notorious examples of the first and most irreversible form of environmental degradation in tropical countries. Environmental appraisal – also called ‘environmental due diligence (EDD)’ or ‘environmental impact assessment (EIA) for sustainable agricultural lending’ - should constitute an integral part of the loan appraisal process, because environmental risk can be translated into credit risk. In fact, an enterprise with environmental problems has a reduced ability to honour loan repayments or contractual business obligations with clients.

In order to arrive at sound lending decisions loan officers should:

identify any environmental issues which are associated with a particular client/loan transaction;

identify and evaluate the financial implications of environmental issues;

minimise exposure to environmental/financial risks.

To achieve better results in the implementation of their lending policies and procedures, financial institutions should appoint a member of management to have the overall responsibility for environmental risk management.

75

Since environmental risk can have serious material financial implications, loan officers should conduct an environmental analysis in an early phase of the loan appraisal process. This is particularly important for lending transactions with a high environmental risk, where more detailed investigations are needed and which may take some time (For more information to conduct environmental analysis see for instance EBRD guidance materials - ‘Environmental Risk Management for Financial Institutions’ http://www.ebrd.com/enviro/index.htm/policy).

Microfinance institutions that work in the agricultural sector like CIDRE in Bolivia have developed a simple worksheet to make an environmental appraisal. This worksheet is used by the loan officers to evaluate possible negative environmental impacts on, for example:

• Water sources: damage to human health, fauna, fish and water ecosystems due to contamination with toxic substances, waste water or acid substances, modifications in the water temperature, drought as a result of the diversion of water sources, etc.

• Ecosystems and biodiversity: loss of wild life because of diminishing habitat, reduced carrying capacity of natural grazing land to support animals because of over exploitation, destruction of the natural landscape, etc.

4.6 Loan Approval and Follow-up

After a loan officer has carried out a loan appraisal, the application has to be prepared for approval and, finally, loan disbursement. Decision-making mechanisms vary from institution to institution and often depend on the loan amount and the proposed loan term. However, in all cases at least one additional officer gets involved in order to respect the “four-eyes” principle of internal control. Let us now have a look at the various steps that follow loan appraisal.

4.6.1 The Loan file

As a first step, the loan officer prepares a loan file in accordance with a pre-defined layout. It is useful to have a standard checklist of all the information and documents that are needed to complete a loan file. A second list showing the people who should sign off when each step of the loan approval process is completed can provide a useful tool to monitor and manage the loan processing time. Many financial institutions set defined benchmarks for the maximum time it should take from the moment of loan application to approval and disbursement.

The loan file should include a summary sheet of the loan appraisal, containing all the key information on the borrower and the loan that has been requested in a very concise form. This summary will help the credit committee to grasp the profile of the proposed loan quickly and thus help them arrive at a decision.

76

The summary sheet used by AGLEND includes the following five key aspects presented on one page:

1. Brief description of the economic activities of the farm household (main crops, livestock, non-farm activities, etc.);

2. Risk profile of the farm household and details of risk-mitigating strategies that are used;

3. Main features of the loan applied for and the recommendation from the loan officer;

4. Financial indicators:

i. accumulated repayment capacity indicator,

ii. free net cash-flow indicator,

iii. indebtedness ratio;

5. Rating results with regard to the personal creditworthiness of the applicant.

AGLEND’s loan officers must present the results of their loan assessment together with a clear statement of all the pros and cons and their final recommendation to the credit committee. A signature by the loan officer under the loan recommendation confirms that an in-depth evaluation of the client’s repayment capacity and willingness to repay has been carried out and sufficient reliable information has been collected to support the stated recommendation.

4.6.2 Loan conditions

An important part of preparing the loan file for the credit committee is the specification of the proposed loan term and other loan conditions. Repayment schedules must be in line with the cash-flow patterns of the farm household. Repayments can only be made when the farm household has cash on hand. Thus, it does not make sense to schedule repayment instalments for periods when the farm household has liquidity shortages, e.g. prior to harvest.

Depending on the household situation, different options exist for appropriate repayment schedules for an agricultural loan:

1. Equal (monthly) instalments of the loan principal and interest due;

2. Regular monthly interest payments and a bulk payment of the loan principal at maturity;

3. Regular monthly interest payments and irregular loan principal repayments when cash is available.

Loans for seasonal crops are generally repaid after harvest (between 4-12 months depending on the crop growth). If family income from other sources is regularly flowing in, at least small payments can be made on a monthly basis. This is often the case with farm households that sell

77

milk on a daily basis or are engaged in vegetable growing or chicken production which have short production cycles.

Let us have a look at the approach that AGLEND uses. We know from the example of Pedro and Maria Crespo that AGLEND’s loan product requires monthly repayment of the loan principal and interest. This is manageable for farm households like the Crespo family, who have various income sources and, consequently, a reasonably regular flow of income.

However, there are farm households with different production patterns that find it difficult to meet the repayment requirement of equal instalments. AGLEND has decided to test out more flexible repayment schedules, which means moving away from their original loan product of equal monthly instalments.

Pedro Crespo has heard about this new possibility and he has told his brother Carlos about it. Carlos wants to start a cattle fattening enterprise. He proposes to buy young cattle, fatten them and sell them at a much higher price after 6 months. He thinks he would need a loan of about $500 to get started.

An AGLEND loan officer visits Carlos Crespo and prepares the following cash-flow projection. He finds out that Carlos keeps pigs and chickens and that he gets a regular income each month from the sale of eggs. The family income is boosted by the wages Carlos’s daughter earns in the local shop, as well as the wages that his son gets from occasional work for a machinery contractor.

After preparing the cash flow projection the loan officer is able to work out a repayment schedule and then reassess the cash flow indicators.

Let us look at the projected figures for the first six months of Carlos's business, including the proposed new cattle fattening enterprise. The loan officer builds in the assumption that Carlos will receive a loan of $500, as he has stated that he does not have any cash savings that he can use.

Here is the cash flow projection for the next six months:

CASH INFLOWS Month: 1 Month: 2 Month: 3 Month: 4 Month: 5 Month: 6Sales of:

Fattened cattle 1000Pigs 360Eggs 40 30 20 20 20 60

Non-farm income 50 60 60 70 70 20Loan from AGLEND 500TOTAL (A) 590 90 440 90 90 1080

CASH OUTFLOWSFarm / business inputs:

Purchase of weaned calves 500

78

Fodder and salt 45 40 50 35 35 35Pig and chicken feed 120

Household expenditure 40 40 70 50 50 50TOTAL (B) 585 80 240 85 85 85MONTHLY NET CASH FLOW (A – B)

5 10 200 5 5 995

CUMULATIVE NET CASH FLOW

5 15 215 220 225 1220

Section for Loan Officer useLoan repayment planRevised MONTHLY NCFRevised CUMULATIVE NCF

Here are the loan repayment calculations made by the loan officer:

Month 1 Month 2 Month 3 Month 4 Month 5 Month 6Proposed instalments -180 -371

Principal -150 -350Interest -30 -21

Outstanding loan balance 500 500 500 350 350 350Interest at 2% p.m. 10 10 10 7 7 7Cumulative interest 10 20 30 7 14 21

You can see that he believes that Carlos can repay part of the principal in month 3 because of his expected sale of pigs in that month. He concludes that the loan can be cleared in two instalments: $180 in month 3 which includes $30 of interest and the balance in month 6. There is not enough cash surplus in the months 1, 2, 4 and 5 for regular monthly payments, not even for regular interest payments.

However, the loan seems to be viable as the accumulated total cash-flow during the 6 months is sufficiently high. When the loan officer enters his repayment calculations in the cash flow projection, the effect is as follows:

MONTHLY NET CASH FLOW (A – B)

5 10 200 5 5 995

CUMULATIVE NET CASH FLOW

5 15 215 220 225 1220

Section for Loan Officer useLoan repayment plan 180 371Revised MONTHLY NCF 5 10 20 5 5 624

Revised CUMULATIVE NCF 5 15 35 40 45 669

Each farm household has a unique combination of economic activities and a unique cash flow. It makes sense, therefore, for AGLEND to make their repayment conditions more flexible and to match their loan terms with the cash flow pattern of each prospective borrower.

79

For farmers who have perennial crops such as coffee, coconut, grapes and others, annual repayments may be the most appropriate, but AGLEND is reluctant to allow such a repayment plan. They require some intermediate repayments, even in the case of perennial crop producers, for the following reasons:

a. Most of the farmers with perennial crops would prefer to make loan repayments when the crop matures, so all their creditors have to “compete” for the available cash.

b. More frequent repayments serve as an important “reminder” to borrowers that they have an obligation with a lending institution. This disciplinary effect is obviously greater with regular repayments such as monthly instalments. However, if this is not feasible, then irregular intermediate payments should be required, just as the one that is proposed for Carlos Crespo.

c. Capturing cash whenever the farm household has some surplus reduces the risk that cash will “disappear”. AGLEND wishes to avoid large sums of cash “burning” in the hands of the borrowers and being used for purposes which reduce timely loan repayment.

d. If borrowers fail to meet intermediate instalment obligations, this provides an early-warning signal to AGLEND that they may have loan recovery problems with a client.

1. What is the accumulated repayment capacity ratio of Carlos Crespo over the six month period of the proposed loan? Does it meet the AGLEND criteria?

Cumulative NCF in Month 6 =

Total loan repayment, including interest =

Accumulated repayment capacity ratio =

2. Use the table below to work out the "free net cash flow" in the two months when the loan officer proposes that Carlos should make his loan repayments. Is it adequate?

Months Monthly Net Cash Flow

(A)

AGLEND Loan Repayment Instalments

(B)

Net Cash Flow after

Repayment A-B=C

Free NetCash Flow

C / B

3 180

6 371

80

3. If Carlos's wife also grows vegetables on which she spends $15 every month and earns an additional monthly income of approximately $28, how does this affect the cash flow? Fill in the revised figures below. Use the section for “Loan Officer use” to show how you would alter the repayment plan based on this revised cash flow.

MONTHLY NET CASH FLOW (A – B)CUMULATIVE NET CASH FLOWSection for Loan Officer useLoan repayment planRevised MONTHLY NCFRevised CUMULATIVE NCF

4.6.3 The Credit committee

Lending decisions are normally taken by a credit committee. However, decision-making should be decentralised, i.e. take place as close to the relevant customers and loan officers as possible. This is essential if large distances exist between branches and district, regional or head offices. Another reason for decentralising credit decision-making is that good loan decisions depend on committee members having good knowledge of the borrowers, the local conditions and the agricultural production systems of the client group.

A credit committee should consist of at least two persons in addition to the loan officer. Loan officers should not vote on committee decisions but just present all the required information regarding the application and provide a clear recommendation for loan approval or rejection.

This is how a meeting would proceed. Loan officers present a summary of the loan request and their appraisal report and then make their recommendation. Committee members listen to the explanation about the proposed loan and are then given an opportunity to put questions to the loan officer regarding the details of the applicant’s economic situation, the feasibility of the loan, the market situation, the applicant’s creditworthiness and repayment capacity, and any other relevant issues. Decisions in the credit committee are made on a consensus basis.

The credit committee is expected to examine the loan appraisal and the recommendation made by the loan officer closely. If any doubts exist about the information gathered or the results of the loan analysis, the credit committee can postpone its decision and ask the loan officer to provide additional information. For instance, if insufficient loan collateral or collateral substitutes have been proposed, the loan officer can be sent back to identify additional collateral. In agricultural lending, however, a fast decision-making process is crucial, since the timing of disbursement is likely to be critical to the success of the farmer’s proposed investment. Therefore, loan files must be well prepared to avoid delays caused by the need to collect additional information.

Decentralised decision-making is only possible if clear thresholds are set for loan approval at branch, district, regional and head office levels. Thresholds that specify the restrictions relating to loan amounts and loan terms are the most useful.

81

At regional and headquarter levels, it may be difficult for loan officers to participate personally in credit committee meetings. In that case they may be represented by their branch or district managers who will have to introduce the loan proposals, based on the loan file and discussions they have had with the loan officers. This can mean that there is less first-hand background information available on the applicants during credit committee discussions. Applications for large or long-term loans normally have to be approved at head office level and, thus, generally take longer to be processed.

4.6.4 Loan disbursement

Once loans have been approved, borrowers should be informed immediately. Since farmers normally live far away from the office, it is important to let them know the date on which the loan application will be presented to the credit committee and when a decision can be expected. Reducing unnecessary travel time for loan applicants is good practice and reduces the transaction costs of the borrower.

There are various methods that can be used for loan disbursement:

Cash disbursement: Many lending institutions disburse loans in cash. They either do this through their own cashiers or by handing a cheque to the borrower that can be cashed at a partner-bank.

Money transfer to an equipment or input supplier: Some agricultural lending institutions prefer to transfer the approved loan amount directly to suppliers. This can increase the level of control over how the loan amount is spent. Although this may be interpreted by the borrower as a sign of mistrust, there are also advantages attached to this system. Firstly, farmers may not want to travel with large amounts of cash, because of the risk of money getting stolen. Secondly, it removes the temptation for the borrower to spend the loan, especially large ones, in a different way from that intended.

Thirdly, financial institutions can establish partnerships with reliable, large agricultural suppliers. They can then either notify the suppliers directly about the approved credit limits of clients so the farmers can go and make their purchases, or clients can be given special coupons to use as cash payment in specific shops. In many cases, these partnerships allow farmers to buy inputs at preferential rates. Fourthly, interest rate calculation will only start on the day when the purchase is made at the supplier or the coupons are actually cashed. This is an obvious advantage compared to the system where the loan is disbursed to the farmer in cash and interest starts accruing whether or not the money has been spent.

Supplying inputs in kind: This system was commonly used in the 1970’s and 1980’s when agricultural lending institutions purchased agricultural inputs and then disbursed them as credit in kind to farmers, normally through state-controlled agricultural input supply companies. In-kind loans are not considered good practice though, since the lending institution becomes implicated in the success or failure of the production activity. If the activity fails, farmers may refuse to repay the loan.

Whatever disbursement method is chosen, it is imperative that the loan is available to the farmer at the moment when it is needed. Late loan disbursement can undermine the entire investment, put the income flows at risk and, hence, endanger the loan repayment. The cash flow projection should indicate clearly when loan disbursement(s) is required.

82

Questions:4. How would you design the loan application and appraisal summary

sheet which is put in the loan file for submission to the credit committee?

5. Which loan disbursement method do you think is the most appropriate in your situation and why? Should disbursement ever be made in instalments?

4.6.5 Loan supervision and monitoring

The success or failure of any financial institution is closely tied to the quality of its loan portfolio and loan supervision and monitoring system. An in-depth assessment of the repayment capacity and creditworthiness of an applicant provides the basis for good loan decisions and thus, portfolio quality. However, good loans may turn into bad ones. In agricultural lending, there are particular risks as we have mentioned before and thus careful monitoring to avoid default is crucial. A monitoring system provides the information needed to oversee loan portfolio quality at any given time, thus identifying potential problems at the earliest possible moment.

There are some key requirements for an appropriate monitoring system for agricultural loans:

a. Open communication between lender and borrower is essential for effective loan monitoring. Some borrowers do not like to tell the lender about problems they may face in repaying the loan. The establishment of a candid and transparent communication can help to ensure that problems are communicated as soon as they arise. If a clear policy on handling problem loans exists and is known to the borrower, it is a powerful incentive for the borrower to provide the lender with early warning signals when he experiences difficult times.

b. Loan files must contain all the documents (loan application, loan analysis, loan collateral records, memos, loan agreement, etc.) which provide a loan officer and other interested parties with a complete historical and on-going record of the relationship between the lender and the borrower. These files are the backbone of a loan monitoring system.

c. Computerisation is essential, if this is not already in place. Although in principle loan tracking can be done manually, this will be difficult beyond a certain number of borrowers with highly individual loan conditions and repayment schedules. An obvious advantage of a computerised loan monitoring system is that reports can be generated automatically. As a speedy response to loan default is vital for maintaining a sound loan portfolio, automation can help to identify problem loans at a very early stage, allowing for immediate corrective action.

Various strategies can be employed to monitor the performance of loans. Let us look at the methods that AGLEND uses to identify potential repayment problems as early as possible.

83

i) Periodic direct monitoring of clients Generally, an agricultural lending institution should stay in close contact with its clients through its loan officers. The loan officer can capitalise on the relationship established with applicants during field visits, the loan appraisal process, and possibly through earlier business contacts. This is not only prudent loan monitoring practice; it is also good customer relations. However, monitoring a loan by personal contact is costly and increases the financial institution's operating expenses.

Client visits

The most effective way to obtain information about the current performance of a borrower is to visit the farm. This gives an opportunity to uncover organisational and operational problems and discuss the current risk management strategies employed by the client.

On-site visits should be timed to coincide with crucial moments in the borrower’s agricultural production cycle, e.g. when crops are germinating, when fertilisers are being applied or just before harvest. Pre-harvest visits are particularly useful to assess the borrower’s repayment potential and to let the farmer feel that he is closely monitored in his/her repayment performance.

Client visits, however, require a lot of time and, hence, represent a significant cost burden for the lending institution. There are other less costly techniques.

ii) Indirect monitoring of clients

Attending local markets, cattle auctions, agricultural fairs

These occasions bring together a large number of farmers. Many farmers, for example, regularly travel to the local and regional markets to sell their produce. There may be monthly livestock auctions and occasional agricultural fairs. At these events AGLEND’s loan officers have a unique chance to meet many of their clients in one single spot! They can observe how well a client business is doing based on his marketing activities and, by talking to other farmers, loan officers may pick up a lot of additional information about their customers.

Meetings with extension staff

In many countries, farm households are assisted by public extension service programmes. Extension workers visit farmers to help them improve their yields and marketing activities. AGLEND loan officers regularly meet with agricultural extension staff to obtain information about farm enterprise productivity levels as well as individual clients. In addition, they learn about any specific risks that threaten certain regions or farmers, e.g. a village hit by a particular pest or a region facing water shortage problems. Meetings with veterinary officers

Another good information source can be veterinary officers who assist farmers with their livestock management. They are aware which farmers vaccinate their cattle and which do not. They also know which farmers have problems with sick cattle or have recently lost a calf for example. This information is very helpful to identify potential problem loans at an early stage.

84

Contacts with agricultural input suppliers, crop traders, slaughter houses, etc.

Agricultural input suppliers, wholesalers, local traders, slaughter houses, irrigation associations and marketing co-operatives also form part of a larger information network. Maintaining contact with these businesses, attending meetings and so on, is just another way of collecting timely information about problems that individual farmers or groups of farmers may face and which might undermine their loan repayment performance.

Other client records in the financial institution

For those lending institutions that offer other financial services as well, additional monitoring devices can be used. A lot, for example, can be learned from a borrower’s current account or savings passbook. If such accounts exist, an occasional check of the account movements can provide useful information to the loan officer about the potential repayment capacity of the borrower.

iii) Monitoring actual loan repayment performance

For those loan borrowers who are in frequent contact with the lending institution because they pay monthly loan instalments, close monitoring of the compliance with the loan repayment schedule may be sufficient.

Accurate and up-to-date information on outstanding loans forms the basis for comparing planned versus actual repayments. Appropriate management information systems (MIS) need to be in place in order to provide loan officers with the information required on their outstanding loan portfolio. If there is no fully integrated and computerised MIS in place, spreadsheets and manually prepared reports have to substitute for automated computer print-outs.

Whether created manually or automatically, some essential reports are required daily by the loan officers.

The set of reports that are regularly produced for each AGLEND loan officer are:

1. Loan portfolio review

2. Due payment report

3. Past-due payment report

4. Loan portfolio at risk report

Let us have a detailed look at these reports.

85

Loan portfolio review

This report lists basic client and loan information and the current outstanding loan amount.

LOAN PORTFOLIO REVIEW – LOAN OFFICER No…

Client Name Client No.

Loan Details Current Outstanding Balance

Date Amount Term Repayment Frequency

Capital Interest

Due payment report

This report indicates which client payments will fall due in the near future. AGLEND produces these reports for the coming two weeks. The report also indicates the main purpose of the loan to help loan officers decide whether a monitoring action such as a client visit is necessary. The loan officer will try to include such visits in his route planning for field visits to new loan applicants in order to minimise time and transport costs.

DUE PAYMENT REPORT – LOAN OFFICER No…Client Name Client

No.Date of Next Due Payment

Loan Purpose Main Economic Activity of Client

Observations/ Action Needed

Past-due payment report

Once repayments are overdue, the loan officer is informed automatically by the institution’s MIS, so that immediate action can be taken to collect the outstanding payments. AGLEND’s loan policy clearly states all the actions that the loan officer is required to take. We will learn more about these policies when we deal with overdue loans in the next section.

86

PAST-DUE REPORT – LOAN OFFICER No…Client Name Client

No. Loan Balance

Amount in Arrears

No. of Payments in Arrears

No. of Days Overdue

Date of Last Repayment

Loan portfolio at risk report

In order to provide an overview of all the loans with repayment problems, an additional report is created by AGLEND, which summarises past-due loans according to the number of days in arrears.

INDIVIDUAL LOANS AT RISK – LOAN OFFICER No…

Client Name Client No. Outstanding loan balance at risk ($)

1-30 Days 31-90 Days 91-180 Days > 180 Days

Total

These reports provide AGLEND loan officers with all the information they need to monitor outstanding loans and to follow-up with their clients in order to ensure repayment.

Questions:

6. What should trigger on-site visits of loan officers to agricultural borrowers?

7. Which loan monitoring mechanisms, other than on-site visits, can be used by an agricultural lending institution to lower their monitoring costs? How does your financial institution balance the costs and benefits of loan monitoring?

87

4.7 Managing Late Repayments and Loan Default

4.7.1 Loan recovery strategy

Loan recovery is essential for all financial institutions which are involved in lending money. It is a good idea to consolidate agricultural lending procedures into an integrated strategy which aims to reduce late repayment and default in the loan portfolio.

AGLEND has compiled the following summary of their strategy.

88

AGLEND Strategy to Ensure Repayment and Reduce Loan Default

1. Design a client selection mechanism which screens out loan applicants with a low repayment capacity and/or willingness to repay.

2. Match the repayment capacity and the repayment schedule as closely as possible to avoid repayment complications.

3. Accept that default problems generally do not occur because of bad clients, but because of poor lending procedures.

4. Establish a reporting system which allows for timely monitoring and follow-up action by loan officers.

5. Establish a reporting system which gives up-to-date information about the loan portfolio quality, trends and possible default risk factors.

6. Instil an ethos in the institution that makes late repayment unacceptable.

7. Establish an incentive system for on-time repayments. The benefits of repaying punctually should clearly exceed the benefits of late repayment.

8. Set maximum levels for late repayment and default as benchmarks for the institution. These levels should be based on a detailed analysis of the costs that arise from late repayment and loan default.

9. If substantial late repayment and default problems exist, set strict but realistic target levels to gradually reduce the numbers involved.

10. Reschedule and restructure loans only after a well-defined loan re-assessment procedure has taken place.

The first five steps have been covered in the earlier sections of this chapter, so we will now focus on the remaining five steps which make up the total strategy of the institution.

4.7.2 Preventing and managing late repayment Late loan repayment is unacceptable for financial institutions. Not only does it signal cash problems and lack of capacity or unwillingness on the part of borrowers to repay, it also interferes with the liquidity strategy of the lending institution and thus, immediately increases the financial costs of the institution. So financial institutions should use a strategy comprised of both “carrots” and “sticks” to keep late repayment to a minimum.

Let us first look at three “carrot” strategies.

1. Loan graduation

A major repayment incentive that is used by a wide variety of financial institutions consists of rewarding good loan behaviour with ready access to further loans. Particularly in rural areas where the financial market is less competitive, access to subsequent loans provides a strong motivation for repaying loans on time. Some rural financial institutions use “stepped lending” as an additional incentive. First-time borrowers start with a small loan and then gain access to higher loan amounts each time they successfully repay the previous loan. In order to make this

89

incentive effective, access to follow-up loans needs to be contingent upon achieving a high level of on-time loan repayments.

AGLEND makes access to future loans contingent on a maximum of two late payments in the past three loan contracts.

In the case of the following customer, this rule has prevented an increase in loan size three times as a result of the number of late payments recorded by the institution’s loan management information system.

CLIENT LOAN HISTORY

Name: Client Number:

Loan contract

Date of disbursement

Termination date

Loan Amount

Loan term No. of late instalments

Qualification for higher loan

amounts

1 11.10.03 11.01.04 1,000 3 Months 1 Qualified

2 02.02.04 02.07.04 1,500 5 Months 3 Not qualified

3 10.07.04 10.11.04 1,500 4 Months 0 Not qualified

4 11.10.04 11.01.05 1,500 3 Months 0 Not qualified

2. Access to preferential lending services

On-time loan repayment can be used to trigger access to loan products which are otherwise not available to the customer. Examples of such services could be “parallel loans” and “easy-access loans”.

Parallel loans may be given for the short-term financing needs of a farm household, e.g. the working capital requirements of non-farm enterprises, such as buying additional stocks for a small shop, or consumption needs such as school expenses or social events. Easy-access loans are granted with a minimum of bureaucratic red tape in the appraisal process. The loan application forms are shorter and simpler and loan appraisal procedures are completed faster. The loans may take the form of an overdraft facility. For the agricultural lender, easy-access loans can be an important way of reducing administrative costs on loans to clients who are known to maintain a good repayment performance.

AGLEND uses the rating system described in the table below to determine whether borrowers qualify for an easy-access loan. It combines an automated calculation of the average number of days by which repayments were late on earlier loans with a qualitative evaluation by the loan officer. This system takes advantage of the personal knowledge a loan officer has of his/her loan clients.

Rating System for PREFERENTIAL LENDING SERVICES

90

RatingComputer rating:

Average no. of days late per payment

Loan officer rating: Client performance

Benefits and Penalties

1 0 to 5 Excellent Repayment of standard loans with a rating of 1 or 2 allows access to preferential loan products.2 6 to 10 Good

3 11 to 20 Regular No access to preferential lending services.

4 21 to 30 Poor No access to preferential services; reduced future loan amounts.

5 > 30 Disqualified Disqualified from receiving new loans.

3. Financial incentives

Clients may be offered a financial discount for repaying all instalments on time. This discount may be in the form of a cash reimbursement once the full loan amount has been repaid or when each instalment is repaid. These repayment incentives, of course, need to be incorporated into the overall loan conditions, in particular the interest rate applied to the loans, in order to maintain the profitability of the institution.

Repayment Incentives used in Bank Rakyat Indonesia

In the Bank Rakyat Indonesia Unit Desa system, a client who receives a $1,064 loan for one year is eligible for a $32 transfer to his/her savings account after making on-time repayments over six months. Subsequent loans may be more than a year away and, therefore, provide little incentive to borrowers to repay on-time. This mechanism, however, provides an effective short-term cash incentive for borrowers. It is estimated that around 90 percent of Bank Rakyat Indonesia small loan clients are eligible for the incentive in most months.

Churchill, C. Client Focused Lending 1999

Now let us look at two “stick” strategies which may need to be applied if, despite the existence of the “carrot” strategies, late loan repayments do occur.

1. Immediate on-site visits

One delinquent client can have a profound influence on the repayment behaviour of others. Rumours spread quickly if it is thought that a lender is lenient about repayments. Other borrowers are then likely to start delaying their repayments, as no serious follow-up action is expected.

Immediate on-site visits when delayed repayments occur is, therefore, essential as a means of transmitting the message that late repayments are not accepted. They also ensure a prompt assessment of the reasons for the late payment. In the case of AGLEND, overdue borrowers are visited within five days of the loan becoming overdue.

91

As we have seen in the previous section, however, it is advisable to make visits to clients before repayment problems actually occur. AGLEND loan officers visit borrowers who have had repayment problems in the past, prior to the due date of a repayment instalment.

When AGLEND loan officers visit delinquent borrowers for the first time, they are friendly, but firm and decisive. Maintaining a good client relationship is important even after a delay in payment has occurred. In fact, strict loan delinquency follow-up is in the interest of the client. The AGLEND loan officer is helping the client to maintain a good credit history with the institution. Advice may also be given on how the client can manage his liquidity better so he can service his financial obligations on time.

A clear policy should be in place regarding further follow-up actions once the on-site visit has been completed. A decision-tree can be useful to provide guidance on which steps to follow in order to increase the pressure on the borrower to repay and to indicate what additional information on the reasons behind the late repayment should be collected.

Immediate on-site visits by the Alexandria Business Association (ABA), Egypt

Borrowers come into face-to-face contact with ABA staff every time they make a repayment. Repayments are made at the bank and customers are asked to bring their receipt book for the loan officer’s signature. This contact is considered an important psychological pressure and it provides an opportunity to discuss problems. However, few loan officers visit their good clients regularly. Instead they visit delinquent clients as a top priority and only if time permits or when they are in the neighbourhood for other reasons, do they visit well-performing clients. If a repayment is late, loan officers deliver a friendly letter signed by the ABA Executive Director which emphasises the need to maintain on-time repayment in order to secure continued access to ABA’s services.

Churchill, C. Client Focused Lending 1999

2. Financial penalties

Delayed payments lead to higher financial and administrative costs for the lender. To cover (at least part) of these costs and to provide an incentive for punctual loan repayment, delinquency penalty fees should be applied. These fees can either be charged on the total loan amount or be restricted to the loan instalment due for payment. The penalty may be applied either from day one of the late payment or after some days of leeway. AGLEND has introduced a tiered system, which increases the penalty rate in line with the number of days in arrears.

Losing access to subsequent loans is a very powerful penalty but lenders also need to consider whether the repayment problems are so severe that the established client relationship should be discontinued. However, if this sanctioning mechanism is never implemented, no signals are being sent that loans should be repaid on time. It must be made clear to borrowers when access to subsequent loans will be denied and when there is still scope to discuss the circumstances and consider further lending. In general, regulations for first-time borrowers should be stricter than

92

those for long-term clients of the financial institution. It is also important not to create an impression that there is an automatic right to further loans when punctual repayments are being made, as an adequate loan appraisal must still be conducted.

93

Questions:

1. The consequences of the rating system for late repayments which is used by AGLEND are quite severe. Clients with payments of more than 30 days overdue will be denied any loans in the future. What are the consequences of this for agricultural loans, e.g. if weather conditions delay the harvest for up to a month? How should an agricultural lender deal with repayment problems caused by factors beyond the farmer’s direct control?

2. What factors would you incorporate in a client rating system? Which set of criteria could make the qualitative judgements on the part of the AGLEND loan officers as objective as possible?

3. What other “carrot” strategies would be useful to encourage on-time loan repayment?

4. What other “stick” strategies would you recommend?

5. Try to draw up a decision-tree for the current procedures that are followed in managing late repayment and loan default in your institution. Do the current procedures allow for timely action?

4.7.3 Managing loan default

If the immediate actions taken by the loan officer when repayment is late do not bring the desired result, further action is needed. Clear systematic procedures are needed to help loan officers decide whether to initiate debt collection mechanisms or whether to enter into negotiations with the client to reschedule or restructure the loan.

Procedure for Deciding How to Tackle Problem Loans

The first step in dealing with loans that have turned out to be problematic is to undertake an analysis of the borrower’s situation. If the result of this analysis is a lack of repayment willingness, fast and prompt debt collection measures should be initiated immediately.

If, on the other hand, a lack of repayment capacity is identified and external factors are the main cause, the future prospects of the borrower’s business, the importance of the customer to the bank, and the value of a continued business relationship with the customer should be evaluated.

If this analysis is negative, debt collection measures should be initiated. If the analysis is positive, a loan rescheduling plan needs to be established in order to get the business and the loan back on track.

Situation analysis

Gathering information about the reasons for default is critical. In agricultural lending in particular there can be many reasons for default to occur.

94

Situation analysis

Lack of repayment capacity

Lack of repayment willingness

Prompt debt collection initiated

Re-evaluation of business prospects

Establish a

rescheduling plan

If positive

If negative

The following diagram gives a summary of possible reasons for loan default and indicates danger signals that should alert loan officers to problems.

Diagram 3 Analysing loan default

The customer is the best source of information on the reasons for default. Additional sources, such as neighbours, suppliers, clients, and other financial institutions, should also be consulted to confirm the validity of the information given. This information-gathering process is usually done by the loan officer.

Some banks place the responsibility for making a situation analysis with a specialised group within the bank. This approach can offer a more objective approach, less influenced by the existing customer relationship. Information collection, however, will be more time consuming, expensive and often less effective. Because of this, many banks hand over to a specialised unit only those cases which are most problematic and represent a significant risk exposure. Others opt to hand over only those problem loan customers who are not considered future clientele. A “no holds barred” approach is then much easier to follow.

Loan rescheduling and restructuring

Once a borrower’s problem has been analysed, a recovery plan may be put in place. The first decision to be made, if this happens, is who will establish and carry out this recovery plan. Most banks decide that the loan officer originally responsible for the loan should also set-up the recovery plan. This is the case in AGLEND. A major rationale for this decision is the idea that the loan officer who carried out the initial loan appraisal, should be responsible for collecting the

95

PROBLEM LOANS

DANGER SIGNALS

Declining profitabilityLiquidity problemsExcessive debt-taking

Government interventionsExport market fluctuationsBusiness / farm cycles

Change in market demandIneffective storage/marketingInput / output price problems

Farmer not informed about market changes

Low morale and rumoursCustomer complains

about "outside" problems

Late repaymentsLow turnover on savings

accountsCurrent accounts overdrawn

Deterioration of loan collateral security

Guarantors have problem loans

Returned chequesDistorted information flows

between borrower and lender

loan. In addition, the loan officer has an indispensable and unique body of knowledge about the customer’s situation.

Loan rescheduling means there is a change in the term structure of an existing loan. Loan restructuring takes this a step further with a possible “refuelling” of the borrower by adding fresh loan money to the existing loan obligation. Both options are extremely delicate and should be handled with the greatest care.

Many microfinance institutions whose clientele consists mainly of traders with a quick turnover often do not allow any rescheduling or restructuring of loans. In agricultural lending, however, both options need to be available due to the high level of external influences on the loan repayment capacity of borrowers. For instance, if unfavourable weather conditions delay a crop harvest, rescheduling may be the only option to ensure loan repayment.

It is important to bear in mind that both loan rescheduling and restructuring are extremely costly for the financial institution. These options should only be chosen if the value generated by maintaining the client relationship and bringing in the outstanding loan exceeds the costs incurred by the loan rescheduling process. It is also important to understand that the extra time spent on a problem loan is basically unproductive – it serves to protect bank assets, but it does not generate additional revenue.

If a delay in harvesting is the cause of the repayment problems, rescheduling the loan is a sensible proposition. Analysis and re-planning activities should, in this case, be designed in a way that minimises unnecessary and excessive re-evaluation costs.

Let us look at AGLEND procedures for dealing with problem loans in more detail.

1. Meet and re-evaluate the borrower: A competent borrower who has fallen victim to an adverse event beyond his or her control is considered worth a concerted effort of revitalisation. The problem borrower of today may be the solid and profitable business client of tomorrow. The on-site visit by the loan officer is the key element in identifying the reasons for repayment problems. If the loan default is clearly due to a lack of repayment capacity, a more in-depth analysis of the business prospects of the borrower is carried out.

2. Review the documentation: All loan documents are re-examined in order to reassess the original loan justification and client situation.

3. Re-evaluate the loan collateral situation: The availability and value of any material loan collateral is checked and compared to the outstanding indebtedness of the borrower. This helps to evaluate the amount at risk.

4. Monitor the borrower’s bank accounts: If the borrower has a savings account, it may be frozen to prevent uncontrolled withdrawals.

96

On the basis of the situation analysis and the assessment of the future business prospects, the loan officer designs a plan of action to be implemented by the lending institution and the borrower. Key criteria for the decision about whether to reschedule or even restructure a loan are:

Reasonable prospects that the borrower can generate enough profits to repay the debt within the stated period of time;

Clear formulation of an appropriate new financial plan and cash-flow projections (an update of the loan appraisal analysis should also be carried out!);

Full borrower commitment to resolving the problems;

Improvement of the lender’s control over the loan situation (e.g. strengthening the loan collateral situation by adding third party guarantors or other forms of collateral).

The basis for rescheduling or restructuring loans is a realistically revised cash-flow projection for the borrower. Revised repayment plans must be based on the outcome of this exercise.

Rescheduling and/or restructuring are normally only part of a loan recovery plan. Easing financial tensions alone is not sufficient to revitalise a borrower’s repayment capacity in most cases. Accordingly, the recovery plans may also include:

Selling non-essential assets;

Advising the borrower to change his marketing strategy;

Seeking advice from agricultural extension staff or business advisory services.

Continuous and close supervision of the implementation of recovery plans is important. On-site inspections by AGLEND should be increased, both in frequency and intensity. All actions taken should be carefully documented in the loan file to provide full transparency.

Once a loan is restructured, AGLEND never considers the loan for further restructuring at a later point in time. There is a clear policy to avoid “ever-greening” the loan portfolio quality by repeatedly rescheduling and restructuring problem loans. Internal control measures also ensure that this phenomenon does not take place.

Debt collection

If measures taken to collect late repayments do not provide the results needed and loan rescheduling or restructuring is either not wanted or not possible, then debt collection will be the final step in the process of following up on problem loans.

Collecting pledged loan collateral through the courts is often a costly and lengthy procedure, especially if property registers are sketchy or collateral is unregistered. Debt collection through claiming collateral items may take months, sometimes even years. Therefore financial institutions in many countries have found ways to avoid involving the courts and increase the speed of debt collection.

97

AGLEND avoids these problems by asking the borrower to sign an agreement through which the ownership over specified assets is transferred immediately to AGLEND. With this document in hand, AGLEND has full control over these assets until the loan is completely paid back. This allows AGLEND to speedily collect loan collateral if it is necessary.

Good days for loan collateral collection are the days when important social events are scheduled to take place. Removing a key household asset at such a time will cause a serious upset and may provoke a “last-minute” repayment!

4.7.4 Improving procedures

Failure to conduct proper loan appraisals is a major reason for loan default and the existence of problem loans. The occurrence of a high number of problem loans should, therefore, be taken as a good reason to reassess the current lending procedures of the institution.

AGLEND, for example, has carefully reviewed its problem loans and has identified various errors. This is what they found to be the key weaknesses in their lending procedures.

1. Poor interviews: Loan officers need to ask precise and probing questions about the loan applicant’s financial situation. A friendly conversation does not suffice.

2. Inadequate financial analysis: Serious problems arise when financial analysis is not at the heart of the lending decision. There is no substitute for a thorough financial analysis!

3. Failure to understand the customer’s business: Loan officers must have a good understanding of the features and dynamics of the customer’s business and agricultural enterprises. If this is not the case, the result may be inappropriate cash-flow projections and inappropriate repayment plans.

4. Inadequate collateral: Accepting loan collateral that has not been properly evaluated with regard to its ownership rights, marketability and commercial value leaves AGLEND unprotected in the case of loan problems. Personal guarantees also need to be thoroughly analysed and cross-checked with existing records.

5. Failure in accurate documentation: Full documentation of loan applications, field visit reports, loan appraisals, credit committee decisions, supporting documents and loan repayment plans is the basis for good loan management and may prevent, if not avoid, problem loans.

98

Questions:

1. Describe the possible reactions of borrowers who are visited by a loan officer, because their loan repayments are overdue. How should the loan officer deal with them?

2. What are “acceptable” reasons for a delay in loan repayment? How should a lender respond to such reasons?

3. Which factors should be taken into consideration when deciding whether or not to collect and liquidate loan collateral assets?

4. Which challenges or constraints in debt collection exist in your country? What mechanisms does your financial institution employ in order to overcome these challenges?

5. Which common errors in lending procedures cause problem loans in your experience?

99

Chapter 5: Agricultural Loan Portfolio Management

Objective: This chapter is designed for loan officer supervisors and branch managers who are responsible for the agricultural lending policy and the overall performance of their institution. It describes the types of risks that may affect the agricultural loan portfolio, explains how to measure the loan portfolio quality, and introduces various management measures that can be taken to actively control portfolio risks.

5.1. Individual versus Portfolio Risk

The risk exposure of an agricultural lending institution is determined by two categories of risks – individual loan risks and loan portfolio risk. Previous chapters have concentrated on individual loan risks; this chapter will focus on loan portfolio risk.

Loan portfolio risk depends on the degree of exposure that individual loans have to covariant risks. For example, in a mainly coffee-growing and exporting region of a given country, a drop in world coffee prices can have serious repercussions on the loan portfolio of a financial institution providing agricultural loans in that region. Coffee producers, processors and traders are all likely to be hit by such a price change. In addition, if a large proportion of people’s income in the region depends on coffee production, manufacturers, importers and retailers of household goods and other consumer items are likely to be hit as well. A prudent financial institution, therefore, needs to take into account these inter-dependent relationships and manage its exposure to loan portfolio risk in an active manner.

What determines the risk profile of the loan portfolio? To start with, each borrower has an individual risk profile. This risk profile needs to be assessed in detail in order to determine whether he/she is eligible for a loan or not, i.e. whether the lending institution is willing to take on the (limited) risk of individual loan default. In the evaluation of individual loan risks, we noted a variety of external factors which are beyond the control of the loan applicant. Price developments in input (e.g. seeds, fertiliser and pesticides) and output (e.g. crop, milk and meat) markets can significantly influence the borrower’s capacity to repay. If these markets show negative trends, it will be difficult for an individual farmer to maintain the projected profitability of his/her economic activities. The capability of the borrower and the techniques s/he applies to mitigate these risks are evaluated at an individual level.

However, regional events, sector and produce market developments can have effects on the overall loan portfolio of an institution far greater than that of any individual borrower. Referring to the example above, if one coffee farmer fails because he is hit by a coffee disease, this is primarily a loan repayment problem for this particular borrower. If all coffee growers in a specific region record crop losses because of this pest, however, and the total amount of loans disbursed to coffee farmers represents a large proportion of the overall loan portfolio, the future of this lending institution might be seriously threatened. Therefore, individual loan appraisal is a must, but is not enough. It must be complemented by risk evaluation and mitigation techniques conducted by the financial institution for its whole loan portfolio.

100

5.2 Loan Portfolio Risk Factors

The key idea of loan portfolio management is to keep covariance risks at a minimum.

The basic principle is to diversify the institution’s loan portfolio over a large number of clients with different risk profiles. Then, if one risk factor turns out to be negative, not all the portfolio will be affected. A simple example for a manufacturing company would be to invest in producing both rain-wear and sun protection products; then, whatever the weather, the manufacturer will sell products.

We will now have a closer look at the three main categories of loan portfolio risks: regional risks, economic sector or product risks, and loan concentration risks.

i. Regional risks

As previously mentioned, there is considerable inter-dependence between farm production activities and other economic sectors in any given region.

The main types of influences on regional risks are summarised in the following diagram:

Diagram 4 Factors influencing regional risks

101

Regional Risks

Macroeconomic conditions

Political condition

s

Geographic conditions e.g. micro-climates

Infrastructure conditions

Ecological conditions

Socio-demographic conditions

Geographic conditions

In agricultural lending, major risks arise from the climatic conditions of the zones where the financial institution operates. In this context, not only the normal climatic features are relevant, but also the region’s exposure to natural calamities such as floods, drought, hurricanes, etc. The variety of flora and fauna in a region and the productivity of agricultural production activities are closely associated with the climatic conditions. The type and frequency of pests and diseases also varies between different geographic zones and climates. Geographic areas with a wide range of micro-climates and accordingly a wider range of agricultural activities undertaken by farmers represent a lower risk to agricultural lenders than areas where all borrowers depend on similar weather conditions and farming systems.

Macroeconomic conditions

In general, the macroeconomic situation of a country has an impact on all economic activities in the different sectors. High inflation and foreign exchange rates, which suggest that the local currency is of little value, may result in high prices for inputs. Particularly goods that must be imported such as certified seeds, fertiliser, chemicals, farm equipment and fuel will be expensive. Although this will have an overall effect on the entire country, the situation might vary between regions depending on the level of dependence on imported goods. Moreover, if a country is experiencing low economic growth, tax revenue will be low, and if it also receives little donor assistance and has limited access to foreign exchange and capital markets, public investment, particularly in rural areas, will be limited. Rural roads and markets may not be constructed; dams and dykes to control flooding may not be built or maintained adequately, the development of irrigation systems may be put on hold; rural education, agricultural research and extension services may be underfunded; and so on.

Political conditions

In many countries, political conditions have been characterised by a high level of government interference in the economy. Unfortunately, the agricultural sector is one of those economic sectors where government intervention has been, and to some degree still is, prevalent. When this occurs, crop prices may be controlled and in the past, publicly-owned agricultural marketing boards were often the only organisations to which farmers could sell their produce. Political leaders have been known to advocate for agricultural debt forgiveness in certain regions or for certain groups of farmers with very negative consequences for loan repayment morale and the overall credit culture. Some countries have trouble with rebel groups operating in certain regions, making the life of farm households very difficult. In Nepal, for example, the Maoist movement has implemented local “parallel governments” in parts of the country. In Colombia, the FARC guerrilla army charges “taxes” to farmers in the regions that they control. In other regions where government troops are still present, they attack trucks that transport agricultural produce to the district towns. In both these countries, public rural infrastructure has been seriously damaged during the conflicts, including crop storage facilities, roads and bridges that are critical for bringing crops from the rural areas to the markets.

Socio-demographic conditions

Socio-demographic factors like population growth, age structure of the population and migration from the rural areas to the cities can also have an impact on the loan portfolio of a rural financial institution. If the size of families increases steadily in a particular region, this may result in more intensive land use. This may lead to overgrazing, reduced fallow periods and crop rotation,

102

increased use of fertilisers and other chemical inputs and, in the long run, deterioration of soil quality and lower crop yields. If farmers migrate more frequently and for longer periods, this can undermine the social networks in a region, destabilising families and cutting off access to family assistance in case of an emergency.

Ecological conditions

Together with geographic factors, the ecological situation of a region has a direct influence on farm production. Contaminated drinking water, for example, can wipe out entire cattle herds and have a negative impact on other agricultural production. Likewise, rapidly increasing erosion problems in a region can seriously affect the continued availability of arable land.

Infrastructure conditions

Access to comprehensive and reliable irrigation systems might be particularly important in regions where the timing and intensity of rainfall is not reliable. Once crops are harvested, there is also a need for adequate local storage facilities as well as for rice mills and other agro-processing facilities. In addition, good transport systems are vital for bringing agricultural produce to the right markets at the right time. Infrastructure does not only refer to physical infrastructure, however. It also includes the availability of agricultural extension services and a minimum number of veterinary officers working in a region, for example.

It is important to remember that all these different regional risk factors do have an impact on individual loan performance. However, they also have major consequences for the overall loan portfolio performance, particularly if they impact on a region where a large number of loans have been granted. Lending institutions should, therefore, have a strong interest in monitoring the risk exposure of their loan portfolio region by region.

ii. Economic sector or product risks

Economic sector and product risks refer to the particular risk profile of a specific economic activity or product. We will first look at the four types of factors influencing sector risks which are shown in the following diagram:

Diagram 5 Factors influencing Sector Risks

103

Sector Risks

Exposure to macroeconomic

risksExpected

sector growth

Expected sector

profitability

Market structure risks

Expected sector growth

It is important to compare the expected growth rate of a particular economic sector with the expected growth of the whole economy. A sector that experiences continuous growth which is above the average for the whole economy is in a good situation. In contrast, sectors with volatile growth rates and sharp ups and downs are more risky for lenders.

Sector growth is influenced by the following factors:

Domestic and international demand for products: If the demand for a product constantly increases, this will have a positive effect on the sector growth rate. Quinoa, for example, was known as a traditional cereal exclusively consumed by the indigenous rural population of the Andean region and it was not even sold in the urban supermarkets of the respective countries until recently. However, with increased international demand for “non-industrial” cereals, quinoa has become a high-value export crop over the last decade and the land area under quinoa production has significantly increased.

Government intervention: Governments may choose to deliberately promote certain sectors and products, while ignoring others. As a result, public investment and support programmes might be particularly beneficial to certain economic activities.

Availability of natural resources or production inputs: Natural resources are limited by nature. The availability of arable land, for example, is not flexible but governed by a combination of geographical features. Taking another example, if overgrazing is already a serious problem, cattle production cannot be further expanded, unless the production methodology changes from an extensive to an intensive, indoor system.

Macroeconomic risk exposure The macroeconomic risk exposure depends on the extent to which certain economic sectors and products are affected by overall economic changes. What impact might overall developments in the national economy have on specific economic activities? For example, a sharp increase in the foreign exchange rate after liberalising money or capital markets is likely to lead to a rise in prices for agricultural supplies that have to be imported. Economic activities that depend heavily on imported inputs will obviously be affected to a much greater extent than those which rely on local inputs.

Market structure risk This risk category is connected to the demand and supply situation of products and the level of competition that exists. For example, if a large number of farm households are engaged in the production of a particular crop, this is likely to result in low prices at harvest time. Conversely if there are only a few specialised producers, they may be able to sell at higher prices. The demand side is also affected by whether there are a large number of clients purchasing the goods or only a few. In Sri Lanka, for example, there are only two large companies purchasing certain vegetables used for decoration (e.g. “bonsai cucumber”), which they export to international hotel chains. Obviously, farmers selling these vegetables are dependent on the conditions that these companies dictate for their purchase, as there are no alternative market outlets to which they can sell.

Expected sector profitability If farm households are engaged in several economic activities and combine different sources of income, having good information about the profitability of any one specific activity is not so crucial for a lender. However, if a financial institution provides loans to farm households that specialise in just one enterprise, then it is essential that the lender knows all about the profitability of that economic activity.

104

iii. Loan concentration risk

Loan concentration risk arises when the loan portfolio consists of a small number of large loans. If one loan fails, then this has a major impact on the loan portfolio quality. Financial institutions which are inclined to insider or connected lending are very subject to this type of risk. Insider lending involves making loans to elected officials, staff and their family members, and business associates of the financial institution, frequently on a preferential basis. In these cases there are often no serious loan recovery efforts when repayments fall due. Loan concentration, default and the permanent roll-over of loans are common features of connected lending.

Another form of loan concentration risk arises when a considerable portion of the loan portfolio is comprised of loans with similar features (e.g. all loans fall due in the same month). Imagine an extreme situation where 100% of the loan portfolio is comprised of 9-month wheat production loans which fall due in the same 2-week period. If the wheat cannot be sold at that particular moment due to a road blockage for instance, there will be a complete lack of liquidity in the financial institution. If the farmers then needed additional loans to store the grain and buy food for their families until the wheat can be sold, the financial institution would not be able to supply them because it would have no cash available. This could have serious implications for the eventual recovery of the loans once the road blockage is cleared and the wheat is finally sold. The grain might have lost quality and only fetch a low price, or farmers may have turned to moneylenders in order to cover their emergency expenses and will pay them back first, before repaying their production loan to the lending institution.

Now let us consider where a financial institution might obtain information from which will help it to assess the three types of risk that affect the quality of a loan portfolio. Information is needed both to construct a general risk profile for economic sectors, products and markets, and to evaluate the specific risk exposure of the institution.

Table 4: Loan Portfolio Risk Categories and Sources of Information

Risk category Sources of information for the risk profile

Sources of information for the risk exposure of the

financial institution

Regional risk Reports from provincial government Past performance per region

Economic sector risk Ministry of Agriculture, Ministry of Small Industries, Chambers of Commerce, Agricultural Extension Services

Internal information sources

Past performance per sector and product

Loan concentration risk

Long term analyses of financial sector

Internal information sources

Past performance per loan type category

105

5.3 Measuring Loan Portfolio Quality

Measuring loan portfolio quality is the key to loan portfolio management. Assessing the current performance status of the loan portfolio – the most important asset of a financial institution - is a basic requirement for being able to actively manage the level of risk exposure and the profitability of the institution.

In general terms, loan portfolio quality indicators identify the performing and non-performing parts of the portfolio and relate them to specific factors. The indicators provide a snap shot of the current status and performance of the portfolio. By comparing indicators at different points in time, a trend analysis can be carried out and positive or negative developments identified. In the search for the reasons for positive or negative developments, loan portfolio information should be structured to enable managers to answer the following questions:

1. What percentage of the loan portfolio is non-performing?

2. What is the ratio of delinquent to active borrowers?

3. How many currently delinquent loans will turn out to be loan losses?

4. How great is loan portfolio concentration in specific regions, economic sectors, products and loan term categories?

5. How does loan portfolio concentration relate to current and past portfolio performance?

As we have already addressed how to monitor individual loan quality, we will concentrate here on the interpretation of aggregated loan portfolio indicators with a particular focus on economic sector and regional risks.

i. Economic sector distribution of the loan portfolio at risk

The loan portfolio at risk is defined as the value of the outstanding principal of all loans in arrears, expressed as a percentage of the total loan portfolio currently outstanding.

Total outstanding balance of overdue loans

Total outstanding loan portfolio

When using this ratio to assess the level of risk, we are assuming that the current level of loan delinquency is not an isolated, temporary phenomenon, but a true reflection of the prevailing situation. In a worst-case scenario the entire outstanding balance of loans in arrears can be lost.

In order to discover which sectors or regions represent a higher risk exposure for a financial institution, the composition of the entire loan portfolio at risk must be compared with the overall loan portfolio structure.

106

AGLEND’s comparative analysis of the total outstanding loan portfolio with the loan portfolio at risk on 31 December 2010 has produced the results which can be seen below.

It is clear that the distribution of the overall outstanding loan portfolio differs significantly from the distribution of the loan portfolio at risk. There are several economic sectors that have a more significant presence in the loan portfolio at risk than they do in the total outstanding loan portfolio. One example is the coffee sector; another one is cattle. This analysis shows that these sectors represent a higher risk to the financial institution than others, because of their higher loan amounts in arrears. Such evidence should be regarded as a red flag for the institution!

Economic Sector

Total outstanding loan portfolio

($)%

Portfolio at risk($)

%

Coffee 284,000 14.2% 40,775 23.3%

Wheat 278,000 13.9% 22,225 12.7%

Rice 214,000 10.7% 19,600 11.2%

Maize 106,000 5.3% 16,450 9.4%

Vegetables 326,000 16.3% 14,875 8.5%

Cattle 196,000 9.8% 26,775 15.3%

Pigs 62,000 3.1% 5,600 3.2%

Poultry 48,000 2.4% 4,025 2.3%

Services 126,000 6.3% 8,575 4.9%

Trade 360,000 18.0% 16,100 9.2%

TOTAL 2,000,000 100.0% 175,000 100.0%

In order to interpret these figures properly, however, several factors need to be taken into account.

Firstly, the table represents a snap-shot of the outstanding loan portfolio at one specific moment in time. The loan portfolio at risk is obviously influenced by the repayment schedules and the maturity of individual loans. Let us assume that all loans for a specific agricultural crop are due in March and that they are paid in one single instalment (including all accumulated interest) at maturity. Obviously, none of these loans will show up as overdue in December. The loan portfolio at risk for this sector would therefore look perfectly fine. However, in March and April the loan portfolio at risk might show a completely different picture. Careful analysis is therefore necessary to avoid jumping to the wrong conclusion.

Secondly, even if the evolution of the outstanding loan portfolio versus the loan portfolio at risk were to be compared over a longer period of 6-12 months, we might not get the correct message. In order to distinguish between temporary and persistent structural repayment problems associated with specific economic sectors, a historic comparative analysis covering several years should be carried out.

107

ii. Economic sector distribution of the loan loss rate

We can carry out a historical analysis of loan portfolio performance by calculating the loan loss rate. The loan loss rate refers to the amount of loans that has actually been written off during a specific period of time. These are explicit losses that a financial institution has acknowledged, because it believes that there is no possibility to recover or enforce repayment of these loans. In a many financial institutions, the loan loss rate is calculated on an annual basis as follows:

Amount written off during period n

Average outstanding loan portfolio during period n

The loan loss rate must be carefully analysed, as it is influenced by the institution's write-off policy. Some institutions wait a very long time before writing-off loans, as they fear that this could be misinterpreted by loan officers and borrowers that the institution is soft on loan repayment. However, as a consequence, the quality of the loan portfolio is over-estimated and a very low loan loss rate may be hiding the real loan portfolio risk level.

AGLEND writes off loans when they are more than 360 days overdue, unless they have to be written off earlier for one of the following reasons:

The borrower has died or disappeared;

The loan collateral or guarantee cannot be enforced, as it is either missing or seriously damaged and/or the guarantor has died or disappeared.

The following table summarises the loan loss ratios as percentages of the loan portfolio for each economic sector. It shows, for example, that 5.9% of the average outstanding loans to the coffee sector had to be written off during 2010.

Sector 2006 2007 2008 2009 2010

Coffee 3.2% 3.1% 3.0% 5.1% 5.9%

Wheat and Rice 2.9% 2.4% 2.2% 2.2% 2.1%

Maize 5.3% 5.4% 16.0% 5.1% 5.3%

Vegetables 0.8% 0.7% 0.6% 0.6% 0.6%

Cattle, Pigs and Poultry 1.5% 1.3% 1.4% 1.5% 1.3%

Services and Trade 0.2% 0.2% 0.1% 0.1% 0.2%

AVERAGE 2.3% 2.2% 3.1% 2.4% 2.5%

The table indicates that not all economic sectors show a stable trend or performance. In 2008, for example, the maize sector had a very bad loan recovery performance with a loan loss ratio of 16.0% of the average loan portfolio outstanding to the maize sector during that year. In the other years it was much lower – around 5%. This shows that in order to interpret the figures correctly,

108

we must have sufficient information about the problems that different sectors faced during the period that we are analysing.Some financial institutions use complex econometric models to find out why there were loan defaults in the past and whether the loan default was the result of individual or broader sector or regional risks, or both. The results of this type of analysis can then transferred into credit scoring models. These can be used to support loan appraisal in a systematic way by identifying the probability with which a new loan might show repayment problems in the future.

Questions:

1. Which sectors contribute more to the loan portfolio at risk than to the overall outstanding loans?

2. Compare the loan portfolio at risk per sector with the historic data provided in the table on loan losses. Does the information of the two tables correspond?

3. What kind of additional information would you require to be able to interpret properly the historic figures about loan losses and current loan portfolio at risk?

4. In which economic sectors has your financial institution shown the highest loan losses in recent years? What are the reasons for these high losses in the different sectors?

Exercise:

AGLEND’s internal audit report for 2010 makes several startling observations regarding the loan portfolio quality. The auditor found that several loans to coffee producers are still registered in the books, even though they have been overdue for several years. If the write-off policies had been applied correctly, these loans would have been written off according to the following scheme:

Year Amount to be written off

Average loan portfolio for coffee sector

2006 12,000 500,000

2007 18,000 550,000

2008 14,000 520,000

1. How would the loan loss rate change for the years 2006-2008, if the write offs had taken place as indicated in the table above in addition to those already carried out?

109

2. With this new information, how would you modify your assessment of the historic loan loss rate for the coffee sector?

110

5.4 Strategies for Active Loan Portfolio Management

Let us now have a look at how agricultural lending policies can be designed to manage loan portfolio risks and what kind of measures can be taken to keep the risks at an acceptable level.

i. Exclusion of certain regions and economic sectors from access to loans

Every lending institution defines a specific target market that it wishes to serve. Among the criteria that are used for determining the target market, risk considerations play an important role. If there are strong indications that loans in a specific region or economic sector will show a high probability of loan default, it may be wise to exclude these groups from access to loans. There is no blue-print for identifying high-risk sectors, however.

Here are some examples of criteria that AGLEND uses to determine which sectors and regions it should avoid:

Areas at risk from frequent, severe and extended periods of natural calamities;

Areas where farm households depend on one main crop which has profit margins that are less than 60% above costs;

Economic sectors which are heavily affected by government intervention in production and marketing;

Regions with a history of subsidised credit programmes (e.g. where more than 50% of the population received loans under these programmes);

Regions occupied by guerrilla movements.

Needless to say, these criteria and also the economic sectors and regions which are excluded from lending need to be modified over time as risks change and new risks arise. If, for example, AGLEND knows that a severe coffee-disease is expanding in a neighbouring country and will soon reach their country, it could decide to cut off lending to this sector until the disease is over. The loan manager must, therefore, continuously observe how the risks associated with specific economic sectors and regions are changing over time and whether they are reaching a level of severity which makes it necessary to stop lending to those sectors and regions.

ii. Inclusion of certain economic sectors and regions only under specific conditions

A less restrictive method than excluding an entire economic sector or region from access to loans is to allow farm households that produce a specific main crop or are located in a specific region to obtain loans – but only under certain circumstances.

If we review the checklist for screening borrowers in section 4.2, for example, we will see that producers of coffee, potatoes and maize are given special treatment. They only pass the screening test if they have a variety of income sources. In the case of coffee and potato producers, they must have a minimum of three different income sources. With regard to maize producers, they must have at least four different sources of income, including one off-farm activity.

111

What conclusions can we draw from this? Coffee, potato and maize producers appear to be classified as high-risk borrowers. They will only be considered for loans if they can off-set the potential problems associated with their main production activity by having other sources of income.

Other conditions which could be defined for any given economic activity include: Minimum level of experience with the activity; Access to irrigation water; Higher collateral requirements, etc.

iii. Economic sector and regional limits

In order to ensure that the loan portfolio is diversified so that major problems in one economic sector or region do not wipe out the majority of the loan portfolio, limits on the proportion of loans that may be granted to specific sectors or regions can be defined. Both lower and upper limits can be set, defining the optimal range that each economic sector or region should occupy in the overall loan portfolio. The lower limit defines the benchmark below which the contribution of a specific sector or region is not expected to fall. The upper limit is the maximum loan portfolio exposure that is considered acceptable for a specific sector or region.

Let us see how AGLEND has defined the upper and lower limits for various economic activities.

Activity Lower limit Upper limit

Coffee 5% 10%

Wheat 10% 20%

Rice 10% 15%

Maize 5% 10%

Vegetables 10% 20%

Cattle 5% 10%

Pigs 2% 5%

Poultry 2% 5%

Services 5% 15%

Trade 10% 30%

As we can see, the largest portfolio concentrations are allowed for trade (10-30%), vegetable and wheat production (10-20%). Obviously, these activities must have lower risk profiles.

How does AGLEND ensure that the actual loan portfolio structure is spread out in the way indicated above? And what does AGLEND do when an upper limit is reached? Does AGLEND close the door in the face of a rice farmer, just because 15% of the loan portfolio is already allocated to the rice sector?

112

First, let us have a look at what can be done to reach at least the lower limit of a regional or sector share of a loan portfolio. Here is a story told by one of the branch managers in the Pramot region:

“... Until two years ago, AGLEND had not given any loans for poultry. Then a 2% lower limit was introduced for this sector and the branch managers were given a 6-month period to achieve this. In order to stimulate our efforts, a competition was organised between the branches. The branch that hit the 2% limit first, would win a big prize. Those that needed more time to achieve the target would get smaller prizes. Those that failed to achieve the target would be penalised with a reduction in their bonus payment.

My branch is No. 1 in the region. So both I and the loan officers wanted to do everything possible to win this prize. Our reputation was at stake! We sat down and made a plan. First, we contacted the local shops where poultry and eggs are sold to find out who were the best poultry producers in the region. We then ranked the poultry producers in terms of their sales volume, quality of produce, reputation etc. Next the loan officers personally visited all the producers at the top of the list.

In order to inform the general public that AGLEND was now interested in financing poultry farmers, we participated in the semi-annual poultry market in our district town. This is a large fair where all poultry producers come together from the region. We held a lottery and more than 300 people participated. The top prize was a cash prize of $10,000. The other prizes were in-kind and included equipment for poultry production and coupons for veterinary services. It was a big marketing success. ...”

Now that we have heard about the successful role of marketing efforts to reach the lower limit, how do we manage the upper limit? What should a financial institution do, if it reaches the upper limit? Let us turn again to AGLEND to see what they did when they hit the 10% ceiling for cattle loans last year. The following policies were applied to implement “credit rationing” for cattle loans:

The loan approval authority was transferred to a higher level. While loans are generally decided at branch level, new loans for cattle producers that would increase the sector share to more than 10% of the overall portfolio were to be decided by the district credit committee. Here, all cattle loans that were submitted from the different branches could be compared. Only the “top” loans were approved and loans with the slightest weaknesses were turned down.

Preference given to existing customers. Preference was given to those cattle producers to whom AGLEND had already given loans. First-time loan applicants were asked to wait.

Stricter borrower selection criteria. The selection criteria for borrowers became more rigid. The benchmarks to be attained in the loan appraisal were increased. Only loan applicants with an excellent repayment history were allowed to obtain new loans. The requirements in terms of accumulated repayment capacity etc. were also increased.

Stricter loan collateral requirements. Collateral requirements for cattle producers became tighter relative to other sectors. Cattle themselves were no longer accepted as the only collateral; additional items such as household goods had to be provided as well.

113

Risk premium. All new loans granted beyond the 10% threshold had to pay an additional risk premium of 1% per annum. This means that borrowers were in fact not being treated equally. A new borrower had to pay an additional charge for increasing the overall risk of the sector portfolio, despite potentially having the same repayment capacity as any of the other cattle producers who had got their loans earlier. Although this seems unfair from the perspective of the individual borrower, it makes sense for the lending institution to obtain compensation for accepting higher exposure to a sector risk in its overall portfolio.

As a consequence of introducing these measures, the cattle producers’ demand for AGLEND loans decreased. By the same token, loan losses in the cattle sector were cut, as the loan repayment capacity and the risk profile of the remaining cattle borrowers significantly improved.

iv. Limits on individual loans in specific economic sectors/activities and regions

Another method which helps to diversify the loan portfolio within each sector or regional sub-portfolio is setting individual loan limits. So the higher the risks associated with a specific economic sector or region, the lower the maximum individual loan amount will be for that sector or region.

Let us have a look at the individual loan limits set by AGLEND, i.e. the maximum loan amount that can be disbursed for various activities.

Economic Sector/Activity First-time borrowers Renewals

Wheat / Rice / Vegetables / Cattle 10,000 50,000

Coffee / Maize 2,000 10,000

Pigs / Poultry 5,000 20,000

Services and trade 20,000 100,000

It is clear that AGLEND treats first-time clients and repeat borrowers differently. Maize is in the group with the lowest limits in both categories. The reason is that maize is considered a high-risk economic activity in the country and AGLEND prefers to finance only smaller maize producers. The highest individual loan limits can be found in the services and trade sectors. These relatively high individual loan limits seem to be the logical consequence of their equally high sector limits noted before. They are considered relatively low-risk activities and large individual loans in these economic sectors do not represent a major threat to the overall loan portfolio quality.

v. Loan provisioning

Loan provisioning is done on a regular basis to cater for potential loan losses. The minimum requirements for provisioning are defined by the Central Bank or the Supervisory Authority for financial institutions in a country. In the event that a lending institution does not have a license as a bank or non-bank financial institution and is not supervised by any local authorities, it is

114

recommended that it follows international best practices as regards provisioning. Provisioning rates normally take into account:

The number of days in arrears; The loan maturity and repayment frequency; The quality of collateral.

It is usual to establish a loan classification system with different rates of provision. AGLEND has the following loan provisioning policy:

Classification Days with overdue payments Provisions

I. Normal 0 days 2-5%

II. Watch < 30 days 25%

III. Sub-Standard 30 – 90 days 50%

IV. Doubtful 90 - 180 days 75%

V. Loss > 180 days 100%

AGLEND caters for the specific risk profile of each economic sector by applying sector-specific provisions for the “normal” category. For the other categories II-V there is no differential treatment by economic sector; uniform provisions are applied regardless of the sector to which the overdue loans belong.

For example, when new loans are disbursed, an up-front provision is made that appears in the "normal" category. When loans are disbursed to high-risk maize producers, a loan loss provision of 5% is set aside. In contrast, the up-front provision for lower risk vegetable producers is only 2%. With this risk-based approach, AGLEND builds up a loan loss reserve that matches the expected loan losses resulting from the risk exposure of each sector.

The additional risk premium applied to maize producers, which is higher than that applied to vegetable growers, is charged to the customer. The credit manager of AGLEND is very clear on this policy: “Not all customers are equal. We have to give them differential treatment. Customers who are less risky than others should also pay less. In contrast, those that represent a higher risk to us should pay an appropriate risk premium.”

It is important that the loan provisioning policy is monitored regularly and adjusted when needed. AGLEND, for example, reviews and adjusts its provisioning policy on a quarterly basis. Whenever the AGLEND management identifies major threats such as an imminent coffee pest or flood, or major disruption in the international crop markets, it reacts immediately and raises the provisions for the loans disbursed to those sectors. AGLEND is not alone in its endeavour to mitigate loan portfolio risks properly. The importance of sound provisioning, for example, was shown when hurricane Mitch hit Central America in 1999. To the surprise of many experts, Financiera Calpiá in El Salvador was not severely affected. Thanks to the large loan loss reserves it had built up, it could weather the storm without major difficulties.

115

vi. Loan write-off policies

Writing-off should be done in such a way as to provide a clear picture about the real situation of the loan portfolio, indicating the true level of (potentially) earning assets. As has already been pointed out earlier in this chapter, AGLEND writes off loans that are overdue for more than 360 days, unless there are explicit reasons for doing so earlier. This benchmark was based on the experience that had been accumulated with overdue loans over a number of years.

Surprisingly, however, it was shown that loans that were overdue for several months could still be recovered in full, if the loan officers and the borrowers worked intensively together on a solution. So although the entire outstanding balance of an overdue loan is already fully covered by loan loss provision after 180 days, AGLEND decided not to immediately write off the loan at that time, but rather to keep it in the loan portfolio for another six months.

Whether a loan is written off or not, however, does not reduce the obligation of a loan officer to continue trying to recover all the loans that he/she originally recommended. Therefore, loan officers continue to try and recover loans that have been overdue even for long periods, including those that have already been written off. This gives a clear signal both internally and externally that there is no lax treatment of problem loans in the institution. This is an important signal that prevents loan write-offs becoming “a simple solution for a bad loan portfolio”.

vii. Differentiated loan monitoring

Loans to high-risk economic sectors or regions should be monitored differently from those that are disbursed to low-risk farm households. In AGLEND, for example, visits to clients primarily engaged in coffee, potato and maize production are scheduled more frequently than visits to borrowers in other less risky production activities. For these more risky sectors, monthly loan repayment instalments are required, which is an additional monitoring device. Also overdue loans in these sectors are followed up more quickly. While a general period of five days is permitted to contact overdue borrowers, AGLEND loan officers are required to contact overdue coffee, potato and maize borrowers within two days.

Questions:

5. What kind of techniques would you apply to ensure that loans to wheat farmers make up between 10-20% of the overall loan portfolio?

6. What medium and long term negative effects might result from the “credit rationing” policy applied by AGLEND to restrict the expansion of loans to cattle producers?

7. Go back to the checklist for screening loan applicants in section 4.2 and review it again from a loan portfolio management perspective. Which economic activities and regions are apparently excluded from access to loans? Which groups can become eligible for loans, if they meet certain conditions?

116

8. Compare the sector limits on page 107 with the actual distribution of the AGLEND loan portfolio shown on page 103. Which sectors are within and which are outside the sector limits? It is possible that the loan portfolio share of a certain sectors is outside the range of defined sector limits. What would you do to control such a situation?

9. Why not develop a loan provisioning policy for your institution that takes into account economic sector and regional risks? Try to define different loan risk categories and an appropriate level of loan provisioning.

Chapter 6: Agricultural Value Chain Finance

6.1 Background

Agriculture around the world is responding to new patterns in consumer demand and undergoing fast and profound changes. As a result, in the agro-food sector, farm production, agro- processing, marketing and distribution firms are subject to rapid transformation and highly integrated food systems are emerging. These are characterized by close linkages amongst the different actors. Much attention is being paid to inter- and intra-business efficiency and there is an increased focus on market competition, product differentiation and marketing. Furthermore, competition is now on a global scale and prices are less affected by specific production conditions, seasonality and local market demand. Today, the provision of tailor made loan products to the different actors in an agricultural value chain, including small farmers, is of high importance and presents both opportunities and challenges to financial institutions. Comprehensive market knowledge and risk management are the main considerations in decisions of financial institutions to engage themselves in agro-food production lending activities.

6.2 Value Chains in Agriculture - Concept and Definition

The concept of “agricultural value chain” covers the full range of activities and actors involved in moving agricultural products from the farmer’s field to the consumer table (from “Farm to Fork”). Before a product reaches the consumer many activities are involved and at each point in the chain, some extra feature is added to the product. A value chain is therefore often defined as a sequence of activities which add value from production to consumption, passing through product aggregation and transportation, agro-processing, storage and distribution.

Value chains are defined by USAID as follows:

“Value chains encompass the full range of activities and services required to bring a product or service from its conception to sale in its final markets –whether local, national, regional or global. Value chains include input suppliers, producers, processors and buyers. They are supported by a range of technical, business and financial service providers.”

117

Diagram 6 Example of the possible links in agricultural value chains:

Value Chain Example

Along its way from the producer to the final consumer an agricultural product will be modified by many different actors. In other words, the product passes through a value chain with value added at each step. A farmer producing wheat for example sells his wheat to a mill. The mill grinds the wheat into flour. The flour is then sold to a bakery that bakes bread and sells that bread to a supermarket where the consumer can buy it.

6.3 Interlinked Credit Arrangements

The commercial relationships between farmers and traders or agro-processors are not only used to pass on commodities, but through trade agreements or buyer/seller contracts for specific products, small farmers also gain access to finance. They may receive credit in kind or in cash. A trader or agro-processor, for example, may advance credit to a farmer from whom he will later purchase the produce. This does not necessarily mean that he provides money to the farmer. He may simply provide seed or fertilizer to the farmer who will pay him back once he has harvested his crop. Normally, the farmer will repay with his produce.

118

Supportinstitutions

Supportservices

Ministry of Agricult.

Ministry of Eco-nomic Development

International Coope-ration Agencies

Universities

N G O s

Fertilizers, pesticides

Machinery & Equipment

Product design

Processing equipment

Export services

Farmers

Buyers

Processing firms

Processed food Natural products

Internal market External market

Irrigation and inputs

Research

Export promotion

Transportation

Quality certification

Technical Assist.

Financial offer for all stakeholders of the agricultural cluster

There are various forms of financial relationships that can be established between farmers and other actors in an agricultural value chain. Three possible mechanisms are outlined below.

1. Supplier and trader credit: This mechanism is normally based on traditional commercial relationships. Farmers receive short-term working capital loans from an input supplier, trader or agro-processor. Usually, farmers receive inputs in kind rather than cash. Financial institutions are typically not involved. There is no long-term relationship established between the actors and there is a risk for the lender. Although the agricultural inputs that farmers get gives them the opportunity to increase their crop yields, they might be tempted to sell their products to another buyer, if that other buyer is willing to pay more, rather than fulfilling their purchase agreement.

2. Contract farming and out grower schemes: In these schemes farmers obtain inputs in kind or cash on credit from an agribusiness firm in the value chain. In return they have to sell their products to this buyer as stipulated in a signed contract. Agreements tend to be long-term and the buyer often supervises the farmers’ production. They may also offer additional services such as technical assistance. Interlinking the supply of agricultural inputs with credit and output marketing works well in a single-channel marketing system or for agricultural commodities that require specialized processing facilities. Where alternative marketing outlets exist, loan repayment may not be guaranteed if the farmer decides to sell to another buyer. Small farmers are disadvantaged by their weak bargaining position, but in a competitive market environment, it should be in the interests of the agribusiness contractor to establish long-term relationships with producers. This will ensure a steady supply of raw materials for processing or of high quality final products.

3. Warehouse inventory credit and warehouse receipts: This financing mechanism does not refer to direct financing of the production of farmers by commercial business partners in the value chain, but instead involves financial institutions. Traders and larger farmers or farmers’ groups can decide to deposit their agricultural products at a bonded warehouse. These licensed warehouses provide farmers with a secure place to store their harvested produce and allows them to sell their products at their convenience, for example when market prices are higher. The farmers receive a warehouse receipt for the products that they store at the warehouse. Financial institutions can then accept the stored products as collateral for the provision of working capital credit to the depositor. Thus, through warehouse receipts farmers get a valuable asset that they can use as collateral for bank loans. The warehouse receipts may be also negotiable to third parties. For the system to work other actors such as the government must be involved in order to establish the appropriate legal and regulatory framework with regard to the general acceptance of uniform agricultural commodity quality standards and loan collateralization.

6.4 Opportunities and Challenges for Value Chain Finance

Internal or direct value chain finance takes place when an agribusiness company advances working capital credit to contract farmers. Conversely, external or indirect value chain finance occurs when a bank decides, for example, to lend to a farmer who has a contract with a trusted agribusiness buyer or accepts as loan collateral a warehouse receipt for stored farm produce issued by a recognized warehouse.

119

Traditional commercial trade partners and new agribusiness actors within the value chain are the main providers of agricultural credit to small farmers and there has been little or no involvement of financial institutions in agricultural production lending. The development, however, of new and dynamic inter- relations between agribusiness and farming in the value chain makes small farmers more attractive as potential bank clients and this may facilitate bank involvement in external or indirect value chain finance.

While uncertainties are inherent in agriculture and affect all actors in a value chain, they impact most on the agricultural producer. Normally, individual small farmers without conventional loan collateral are not even able to apply for loans, but financial institutions working with an agribusiness company may decide to provide contract farmers with access to the working capital they require. Financial institutions may prefer to channel their lending resources through the company. Then at the time of produce delivery, the agribusiness contractor can first recover the production credit owed to the financial institution before giving the contract farmers their payments. In this way, financial institutions can cut down substantially on their transaction costs as well as reduce their credit risk.

The opportunity that value-chain finance offers financial institutions lies in the fact that it complements and builds upon the strength of existing value chain relationships. The benefits of strong business relationships – secure market outlets and high production skills – make small farmers much more creditworthy for banks. At the same time, regulated financial institutions are able to offer clients a wider range of financial services than agri-business companies, such as savings/deposit facilities, money transfer, and credit both for working and investment capital.

Banks that decide to extend their operations into value chain finance need to invest sufficient time and resources in capacity building for their staff to increase their knowledge of agricultural value chains. Loan officers require a comprehensive understanding of all the actors, their dynamic inter-relationships and the relevant markets for each of the main agricultural value chains. Once they “know their business” they will be able to assess the credit risks in each chain at different levels and be able to propose feasible strategies to mitigate them. A good knowledge of the nature and needs of each actor in the chain will also make it possible to tailor appropriate financial products.

In a value chain approach loan appraisal procedures for prospective small farmer borrowers consist of a combination of in-depth value chain assessment and appraisal of the repayment capacity of a “typical” contract farmer. The assessment of individual creditworthiness focuses on the character of the individual farmer and his potential for growth. As such it contrasts greatly with the conventional bank agricultural lending approach, which deals with a wide range of business activities and individual clients, and the loan officers are required to assess the creditworthiness and repayment capacity of each individual farm household.

120

Answers to questions involving calculations:

Page 68

Q.1: Revised free net cash flow ratio for June: 0.45

Revised free net cash flow ratio for July: 5.29

Page 79

Q.1: Cumulative NCF in Month 6 = 1220

Total loan repayment, including interest = 551

Accumulated repayment capacity ratio = 2.2

Q.2

Months Monthly Net Cash Flow

(A)

AGLEND Loan Repayment Instalments

(B)

Net Cash Flow after

Repayment A-B=C

Free NetCash Flow

C / B

3 200 180 20 0.1

6 995 371 624 1.7

The free net cash flow ratio in month 3 is clearly too low.

Page 80

Q.3:

MONTHLY NET CASH FLOW (A – B)

18 23 213 18 18 1008

CUMULATIVE NET CASH FLOW

18 41 254 272 290 1298

This is an example of a revised repayment plan in which interest is now being paid monthly and the instalment of loan principal scheduled for month 3 has been reduced to $100, leaving an outstanding balance of $400 for the remaining months.

Section for Loan Officer useLoan repayment plan 10 10 110 8 8 408Revised MONTHLY NCF 8 13 103 10 10 600Revised CUMULATIVE NCF 8 21 124 134 144 744

121

Page 105

Exercise:

Revised loan loss ratios for coffee:

Economic Sector 2006 2007 2008

Coffee 5,6% 6,4% 5,3%

122