Risk Management In Agricultural Finance

RESEARCH REPORT ON RISK MANAGEMENT IN AGRICULTURAL FINANCE

SHAFQAT ULLAH

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR PAKISTAN May 2007

RESEARCH REPORT ON RISK MANAGEMENT IN AGRICULTURAL FINANCE

Research report submitted to the Institute of Management Sciences Peshawar in partial fulfilment of the requirements for the degree of Master in Business Administration

May 2007

INSTITUTE OF MANAGEMENT SCIENCES PESHAWAR

RESEARCH REPORT ON RISK MANAGEMENT IN AGRICUTURAL FINANCE

Supervisor:

Signature

______________________

Name

Mr. Muhammad Rafiq

Designation

Coordinator BBA

Coordinator Research & Development Division:

Signature

____________________

Name

Mr. Owais Mufti

PREFACE

Research report is the last step in completion of the MBA degree. This is an excellent and interesting part of the course because a lot is learnt during the research writing. This helps students in analysing different problems not only for the course requirement but also for future career.

The present research is about different risks associated with agricultural finance and its effective management by agricultural credit institution and agricultural credit department of commercial banks.

The reason for selecting agricultural finance sector for the research is that 50% of the workforce of the country are involved agriculture and agricultural finance is one of most important and inseparable part of agricultural business. Risk is a necessary part of agricultural finance because agriculture is a risky business and the risk is transferred to agricultural lending institution since they are connected with agriculture business. Banks surely need an effective risk management policy to cope with the risks involved in agricultural finance.

Such a research will not only help institutions lending for agricultural purposes but also people connected with agriculture, livestock etc businesses. And sure this research report will play its role in this respect.

Shafqat Ullah MBA (Banking & Finance)

TABLE OF CONTENTS Topic

Pa ge #

P refac e

i

Tab l e o f C o n t en t s

ii

Li s t o f Gr ap h s

iv

Ex ecu t i v e S u m m ar y

v

S E CT I O N O NE : INT RO DUCT I O N

1-4

Ch a p ter 1 1 . 1 Bac k gro u n d

1

1.2 Risk

2

1 . 3 R i s k M an ag em e nt

2

1 . 4 Ob j ect i v es o f t he S t u d y

3

1 . 5 S co p e o f t h e W ork

3

1 . 6 S ch em e o f t h e R epo rt

3

S E CT I O N T WO : RE VI E W O F L I T E RAT URE

1 1 -3 0

Ch a p ter 2 : Rev i ew of L i tera tu re

11 -2 3

Ch a p ter 3 : Ri s k an d Ri s k Ma n a geme n t

24-3 0

3.1 Risk

24

3 . 1 . 1 S ys t em at i c R i s k

25

3 . 1 . 2 No n-s ys t em at i c R i s k

25

3 . 2 R i s k M an ag em e nt

25

3 . 3 R i s k M an ag em e nt P ro ces s

26

3 . 3 . 1 R i s k Ident i fi c at i on

27

3 . 3 . 2 R i s k As s es s m en t

27

3 . 4 P o t en t i al R i s k Treat m en t s

28

3 . 4 . 1 R i s k El i m i n ati o n

28

3 . 4 . 2 R i s k M i t i gat i on

29

3 . 4 . 3 R i s k R et en t i on

29

3 . 4 . 4 R i s k Tran s fer

30

3.5

Li m i t at i on s

S E CT I O N T H REE : ANAL YS I S

30

3 1 -3 4

Ch a p ter 4 : An a l y s i s 4 . 1 C au s e-an d- Eff e ct Anal ys i s

31

4 . 2 C au s es o f Li qu i di t y R i s k

32

4 . 3 C au s es o f Ope r at i o nal R i s k

33

4 . 4 C au s es o f M ark et R i s k

33

4 . 5 C au s es o f W eat her R i s k

34

4 . 6 Th ei r Eff ect

34

4 . 7 Ag ri cu l t u re C re di t Del i ver y

35

S E CT I O N FO UR: RE CO MME NDAT I O NS

3 7 -3 8

CO NCL US I O N

3 9 -4 0

RE FE RE NCE S

4 1 -4 3

LIST OF GRAPHS Nu mb e r

Fi g u re T i tl e

Pa g e

Fi gu re 3 . 1

R i s k Treat m en t

28

Fi gu re 4 . 1

Fi s h bo ne Di a gr am

32

Fi gu re 4 . 2

Effect s on P rofi t ab i l i t y

34

Fi gu re 4 . 3

C redi t R eq ui rem ent & Di s bu rs em ent

35

EXECUTIVE SUMMARY The present research study has been conducted to identify different types of risks associated with agricultural finance, their possible effects of profitability of agricultural lending institution and risk management strategies that have been designed to cope with these risks.

Agriculture businesses have great exposure to risk and this risk not only affects the farmer but also the institution lending to farmer for agricultural purpose. Risk has serious consequences for income generation and for loan repayment capacity of borrower. Agricultural insurance is a useful tool to manage the risks but it has limited role in agriculture sector of Pakistan especially small farmers have almost no access. Problems associated with inadequate loan collateral pose specific problems to agricultural lenders.

Lenders consider movable assets, such as

livestock as higher risky forms of security. Market and price risks are due to market fluctuations in prices particularly where information is lacking and where markets are imperfect. The relatively longer time period between cultivation and harvesting means that market prices are unknown at the moment when a loan is granted. Free trade and exposure to foreign markets increases price risk for farmers. Countries with smaller markets experience more volatility than markets with large volume trade. The dispersed farmer-borrowers with small loan volumes lead to high financial transaction costs both for borrower and institution and increase perception of high risk.

Mismatching the term of loan assets and

liabilities exposes a financial institution to high liquidity risks. The liquidity position of agricultural lenders is affected by agricultural seasonality. To protect themselves, banks should carefully match maturity of their loans with that of their loanable resources.

Risk is defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risk of an organisation or system may be exposed to depend upon a number of factors such as size, complexity, business activities, volume etc. Risk management is the process of measuring or assessing

risk and developing strategies to manage it. Strategies may include transferring of the risk, avoiding the risk, reducing the negative effects of the risk and accepting some of the consequences of the risk. Traditional risk management covers actions taken both before and after the risky events occur.

By analysing these risk by fishbone diagram which is developed by Dr. Ishikawa, it is clear that there are four major categories that affects the banks’ profitability. Weather risk, liquidity risk, operational risk and market risk collectively have mostly negative effects on banks’ profitability and therefore often institutions hesitate in forwarding loan to this sector and eventually the credit demand is not covered by the supply of credit.

To effectively manage these risks financial institutions need to classify the loan in terms of risk and should first start lending in low risk zone and then gradually to high risk zone. The credit risk should be minimised by appropriate collateral and information database of borrowers’ creditworthiness. The repayment schedule should be designed as such that is convenient for borrower to repay the loan on time with interest. Market risk can be minimised by diversifying income generation sources for rural household. The institution has to design effective risk management policy and consistently follow it.

CHAPTER: 1

INTRODUCTION 1.1 BACKGROUND: Agriculture is of vital importance in Pakistan’s economy. It accounts for about 22% to the GDP and about 66% to export earnings. Not only 44.8% of the workforce are engaged in agriculture but also 65.9% of the country’s population is living in rural areas, which is directly or indirectly related to agriculture for their livelihood. Any effect on agricultural performance would affect the large number of population and of course the growth of the country’s economy as well. The performance of agriculture has been weak during the fiscal year 2005-06. Overall agriculture grew 2.5% against the target of 4.2% which is very low as compared to 6.7% which is the achievement of year 2004-05.

Farmers need seeds, fertilisers, pesticides, agricultural machinery, labour and farm houses etc and for this they demand funds if they are in short of money for operation of these activities. This demand is fulfilled by financial institutions, banks, and co-operatives, NGOs and or by their relatives, friends. But the main supplier of credit to farmers is financial institutions, co-operatives etc.

In Pakistan there are some specialised agricultural finance institutions such as ZTBL. Other than these the agricultural credit departments of commercial banks are also engaged in lending for agricultural purposes. A total of Rs. 111195.168 million was disbursed as loan by all financial institutions for agricultural purposes during the period of July 05 to Mar07; Rs.91160.959 million was disbursed during corresponding period last year.

Although there is an increase in agricultural credit disbursement but still the credit supply is not consistently increasing as the demand is increasing. The reason is that there many risks involved in agriculture and therefore institutions hesitate to

advance loan for agricultural purposes. The present research is related to same topic that how different risks involved in agricultural finance affect the profitability of a bank and how it can be managed effectively.

1.2 RISK: “The

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

impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives.”1

1.3 RISK MANAGEMENT: Risk management is a very critical issue in many sectors as well as in agricultural finance.

Agricultural finance needs even more and better risk management

strategies because agriculture is comparatively more risky business.

“Risk management is the process of identifying, measuring or assessing risk and developing strategies to manage it.”2

1.4 OBJECTIVES OF THE STUDY: The main objectives of the study are to 1

Find out different risks involved in agricultural finance faced by financial institutions, co-operative societies, NGOs etc

2

Determine the effects of these risks on the profitability of agricultural lending institutions.

3

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

4

And to suggest recommendations to manage these risk effectively

1 2

Definition by State Bank of Pakistan Definition by Wikipedia Encyclopaedia

1.5 SCOPE OF THE WORK: Agricultural finance is faced with many challenges because agriculture is a very risky business and this risk is then transferred to agricultural lending institutions because they are connected to it. Since there are many challenges faced by agricultural finance therefore it is not possible to cover all of them in this research report.

Therefore this research is limited to the risk management challenge in agricultural finance. It will cover different risks that financial institutions are facing with in lending to farmers for agricultural purposes.

Weather risk will be covered in the research that is the main risk in agriculture. Other than this liquidity risk, credit risk, operational risk etc will be covered in this research report.

1.6 SCHEME OF THE REPORT: The first section of the report is the introduction section, in which background of the topic is discussed. Risk and risk management is defined, objectives and scope of the research report is described.

In the second section the viewpoints and findings of different researchers on similar topics have been discussed and comprehensively define risks, its different types, risk management and risk management process.

In the third section the problems are analysed by using fishbone diagram and using some data to analyse agricultural finance challenges.

The fifth section of the report is about recommendations. And at the end the report has conclusion and references.

CHAPTER: 2

REVIEW OF LITERATURE Agriculture remains a dominant activity in many rural economies of the poorest nations in the world. A large majority of the poorest households in the world are directly linked to agriculture in some fashion. Risks in agriculture are most certainly not independent in nature. When one household suffers bad fortune it is likely that many are suffering. These common risks are referred to as correlated risk. When agricultural commodity prices decline everyone faces a lower price. When there is a natural disaster that destroys either crops or livestock, many suffer. Insurance markets are sorely lacking in most developing and emerging economies, and rarely do local insurance markets emerge to address correlated risk problems. (Skees, Jerry 2003)

Agricultural risk is associated with negative outcomes that stem from imperfectly predictable biological, climatic, and price variables. These variables include natural adversities (for example, pests and diseases) and climatic factors not within the control of agricultural producers. They also include adverse changes in both input and output prices. To set the stage for the discussion on how to deal with risk in agriculture, we classify the different sources of risk that affect agriculture.

Agriculture is often characterised by high variability of production outcomes or, production risk. Unlike most other entrepreneurs, agricultural producers are not able to predict with certainty the amount of output that the production process will yield due to external factors such as weather, pests, and diseases. Agricultural producers can also be hindered by adverse events during harvesting or collecting that may result in production losses. (World Bank Report 2005)

Risks impact borrowing farmers and the financial institutions that lend to them. Active management can reduce these risks. Risks and uncertainty are pervasive in

agricultural production and are perceived to be more serious than in most nonfarm activities. Production losses are also impossible to predict. They can have serious consequences for income-generation and for the loan repayment capacity of the borrowing farmer. The type and the severity of risks which farmers face vary with the type of farming system, the physical and economic conditions, the prevailing policies, etc. (Klein, B., Meyer, R., Hannig, A., Fiebig, M 1999)

Risks can be of different natures and include those associated with the impact of unfavourable weather on production, (drought, hail, floods), diseases or pest damage, economic risks due to uncertain markets and prices, productivity and management risks related to the adoption of new technologies, and credit risks as they depend on the utilisation of financial resources and the repayment behaviour of farmer clients. The relative importance of these different risks will vary by region and by type of farmer. For example, marketing risks are greater for monocrop cultures in developing countries, which depend on volatile world markets. These risks will also decrease as the level of education of farmers and the availability of information on markets, prices and loan repayment behaviour increase. In some cases, especially for relatively high technology farming that involves significant investments, agricultural insurance may be useful as a risk management tool. But it should be used only for specific crop/livestock enterprises and for clearly defined risks (Roberts and Dick, 1991; Roberts, R.A.J and Hannig, A 1998)

Agriculture is inherently dependent on the vagaries of weather, such as the variation in rainfall. This leads to production (or yield) risk, and affects the farmers’ ability to repay debt, to meet land rents and to cover essential living costs for their families. But the effects of weather events also matter for rural lending institutions and agri-businesses, as they determine the risk exposure of borrowers and input providers. With weather conditions affecting a large share of business activity, many developing countries in Sub-Saharan Africa and other parts of the world display a high sensitivity of both agricultural and GDP to fluctuations in rainfall (Benson and Clay, 1998 and Guillaumont, Guillaumont,

Jeanneney and Brun, 1999). Ultimately, the precariousness of farmers and producers translates into macroeconomic vulnerability.

Developing countries are not just more dependent on weather conditions but also suffer the brunt of natural disasters (due to the hazardous environmental conditions), many of which are caused by weather hazards. According to World Bank (2001), between 1988 and 1997 natural disasters claimed an estimated 50,000 lives a year and caused direct damage valued at more than US$60 billion a year. Developing countries incurred the vast majority of these costs: 94% of the world’s 568 major disasters between 1990 and 1998 took place in developing countries. In Asia, which experiences 70% of the world’s floods, the average annual cost of floods over the 1990s was estimated at US$15 billion. On the basis of current trends, these numbers are likely to rise in the future. (Freeman, 1999).

Farmers in developing countries have always been exposed to weather risks, and for a long time have developed ways of reducing, mitigating and coping with these risks (Dercon, 2002). Traditional risk management covers actions taken both before (ex-ante) and after (ex-post) the risky event occurs (Siegel and Alwang, 1999). Examples of ex-ante strategies include the accumulation of buffer stocks as precautionary savings and the diversification of income-generating activities through changing labour allocation (working in farm and non-farm small businesses, and seasonal migration) or varying cropping practices (planting different crops, like drought-resistant variants, planting in different fields and staggered over time, intercropping, and relying on low risk inputs). Similarly, companies may self-insure through high capitalisation and diversification of business activities. Communities collectively mitigate weather risks with irrigation projects and conservation tillage that protects soil and moisture. Examples for ex-post strategies range from farmers seeking off-farm employment, to distress sales of livestock and other farm assets, to withdrawal of children from school for farm labour, and to borrowing funds from family, friends and neighbours (Hanan and Skoufias, 1998).

When a hurricane or an earthquake occurs not everyone has a total loss. Still, many losses do occur at the same time. Crop losses have similar characteristics. While events such as too little rain, too much rain, or widespread frost create widespread crop losses, not every farm experiences the same loss. The challenge for those insuring losses from hurricanes, earthquakes, and crop disasters is to have access to enough capital to cover worst-case scenarios. Since catastrophic risks are not independent, and in the classic sense are uninsurable, special global markets have emerged to share these risks. The traditional mechanism is to share catastrophic risk with another insurance entity by what is called reinsurance. Reinsurance can take many forms. The simplest form to consider is another insurance policy on the insurance losses for a local insurance provider. Such a policy can be arranged as a ”stop loss” policy: The local insurance provider pays a premium to the global re-insurer who agrees to pay for all losses beyond a certain threshold. As long as the re-insurer mixes this into a global book of business, then what were correlated risks at the local level become independent risks at the global level. (Skees, Jerry 2003)

Management of yield or price risk through the purchase of crop insurance transfers risk from you to others for a price which is stated as an insurance premium. Crop insurance is an example of a risk management tool that not only protects against losses but also offers the opportunity for more consistent gains. When used with a sound marketing program, crop insurance can stabilise revenues and potentially increase average annual profits.

Crop insurance provides two important benefits. It ensures a reliable level of cash flow and allows more flexibility in your marketing plans. If you can insure some part of your expected production, that level of production can be forward-priced with greater certainty, creating a more predictable level of revenue. With the elimination of ad hoc disaster payments and deficiency payments, crop producers will no longer receive government aid during years of crop disasters or price support payments during low price years. Crop insurance provides partial replacement for the Federal safety net. (Kaan, Dennis)

Insurance is another formal mechanism used in many countries to share production risks. However, insurance is not as efficient in managing production risk as derivative markets are for price risks. Price risk is highly spatially correlated and, as illustrated by Figure 2.1, futures and options are appropriate instruments to deal with spatially correlated risks. In contrast, insurance is an appropriate risk management solution for independent risks. Agricultural production risks typically lack sufficient spatial correlation to be effectively hedged using only exchange-traded futures or options instruments. At the same time, agricultural production risks are generally not perfectly spatially independent and therefore insurance markets do not work at their best. Skees and Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et al. (1982), “good or bad weather may have similar effects on all farmers in adjoining areas” and, consequently, “the law of large numbers, on which premium and indemnity calculations are based, breaks down.” In fact, positive spatial correlation in losses limits the risk reduction that can be obtained by pooling risks from different geographical areas. This increases the variance in indemnities paid by insurers. In general, the more the losses are positively correlated, the less efficient traditional insurance is as a risk-transfer mechanism. For many ideas presented in this document, a precondition for success is a high degree of positive correlation of losses.

Agricultural insurance has a limited role in farming, in particular for small farmers. Its applicability in any given situation is defined by the test as to whether it is the most cost-effective means of addressing a given risk. When it has a role the resulting action should be attached to existing insurance operations in order to take advantage of existing insurance expertise, record keeping and accounting systems and equipment. On the other hand, agricultural insurance operations require some special skills. This approach can partly be provided through manuals, but personal observation through study tours of efficient crop insurance programs can also be useful.

Mechanism used in many countries to share production risks. However, insurance is not as efficient in managing production risk as derivative markets are for price risks. Price risk is highly spatially correlated and futures and options are appropriate instruments to deal with spatially correlated risks. In contrast, insurance is an appropriate risk management solution for independent risks. Agricultural production risks typically lack sufficient spatial correlation to be effectively hedged using only exchange-traded futures or options instruments. At the same time, agricultural production risks are generally not perfectly spatially independent and therefore insurance markets do not work at their best. Skees and Barnett (1999) refer to these risks as “in-between” risks. According to Ahsan et al. (1982), “good or bad weather may have similar effects on all farmers in adjoining areas” and, consequently, “the law of large numbers, on which premium and indemnity calculations are based, breaks down.” In fact, positive spatial correlation in losses limits the risk reduction that can be obtained by pooling risks from different geographical areas. This increases the variance in indemnities paid by insurers. In general, the more the losses are positively correlated, the less efficient traditional insurance is as a risk-transfer mechanism.

The lack of statistical independence is not the only problem with insurance in agriculture. Another set of problems is related to asymmetric information — a situation that exists when the insured has more knowledge about his/her own risk profile than does the insurer. Asymmetric information causes two problems: adverse selection and moral hazard. In the case of adverse selection, farmers have better knowledge than the insurer about the probability distribution of losses. Thus, the farmers have the privileged situation of being able to discern whether or not the insurance premium accurately reflects the risk they face. Consequently, only farmers that bear greater risks will purchase the coverage, generating an imbalance between indemnities paid and premiums collected. Moral hazard is another problem that lies within the incentive structure of the relationship between the insurer and the insured. After entering the contract, the farmer’s incentives to take proper care of the crop diminish, while the insurer has limited

effective means to monitor the eventual hazardous behaviour of the farmer. This might also result in greater losses for the insurer.

Since both price and yield risk for agricultural commodities are spatially correlated, rural finance markets are often limited in their ability to help individuals either smooth consumption or manage the business risk associated with producing crops and livestock. For that matter, any form of collective or group action assisting individuals to manage correlated risk at the local level is doomed. (Skees, Jerry 2003)

Yield uncertainty due to natural hazards refers to the unpredictable impact of weather, pests and diseases, and calamities on farm production (Ellis, 1988). Risks severely impact younger, less well-established, but more ambitious farmers. Especially affected are those who embark on farming activities that may generate a high potential income at the price of concentrated risks - e.g. in the case of high input mono-culture of maize. Subsequent loan defaults may adversely affect the creditworthiness of farmer borrowers and their ability to secure future loans. (Klein, B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

A conventional bank practice that protects the lender against possible borrower default is the requirement of loan collateral such as real estate or chattel mortgage. Banks use loan collateral in order to screen potential clients (as a substitute for lack of customer information) and to enforce and foreclose loan contracts in the event of loan default. The preferred form of conventional bank collateral is mortgage on real property, which, however, requires clear land titles and mortgage registration. In general, real estate and land are considered to be “low risk”, while chattel mortgages of movable assets such as machinery and animals incur a greater risk, unless these items can be clearly identified, and are properly insured against theft, fire and loss. In the absence of conventional types of collateral such as land, livestock and machinery, other forms of supplementary collateral are sometimes accepted by banks, such as third party guarantees, warehouse receipts and blocked savings. Without secure loan collateral, it is

expected that there will be a contraction in the supply of bank credit and this will result in reduced access of small farmer and rural clients to finance.

In the informal credit market, where intimate client knowledge and, often, interlinked trade/credit arrangements exist, non-tradable assets or collateral substitutes, such as reputation and credit worthiness, are much more prominent. Group lending based on group control and joint and several liability of group members, and group savings are suitable forms of collateral substitutes. These are increasingly used by donors and NGOs. It may be effective if groups are homogenous in their composition, interests and objectives and when problems of moral hazard can be avoided. However, in many countries, groups of farmers do not easily meet these criteria. In addition, also due to the long duration of agricultural loans and high costs of group training, individual lending in agricultural finance, in general, is much more widespread and might be more appropriate than group lending. Moreover, successful experience with group lending is chiefly for non-agricultural purposes. (Binswanger and McIntire, 1987)

Problems associated with inadequate loan collateral pose specific problems to rural lenders. Land is the most widely accepted asset for use as collateral, because it is fixed and not easily destroyed. It is also often prized by owners above its market value and it has a high scarcity value in densely populated areas. Smallholder farmers with land that has limited value, or those who have only usufruct rights, are less likely to have access to bank loans. Moveable assets, such as livestock and equipment, are regarded by lenders as higher risk forms of security. The owner must provide proof of purchase and have insurance coverage on these items. This is rarely the case for low-income farm households.

Moreover, there are a number of loan contract enforcement problems, even when borrowers are able to meet the loan collateral requirements. Restrictions on the transfer of land received through land reform programmes limits its value as collateral - even where sound entitlement exists. In many developing countries the poor and especially women have most difficulties in clearly demonstrating their

legal ownership of assets. Innovative approaches which draw on the practices of informal lenders and provide incentives to low income borrowers to pay back their loans have been developed in micro-credit programmes.

Credit risk arises with all over-the-counter contracts as both parties have promised to pay the other in the future, depending on the final value of an index, and must be trusted to live up to the promise. This can be contrasted with exchange-traded securities where the exchange assures final payment. Credit risk or the risk of default of the counterpart in emerging markets is compounded by currency transfer risk. In other words it does not matter to the weather risk provider whether the default is triggered by a macro problem (the Peso crisis, for example) or counterpart default the risk rating will be equal or lower to the country risk rating.

Risks are also related to the duration of loans, since the uncertainty of farm incomes and the probability of losses increases over longer time horizons. Thus, given the average short maturity of loan-able resources in deposit-taking financial institutions, and considering the time horizon of agricultural seasonal and investment loans, commercial bankers are normally reluctant to engage themselves in agricultural lending. To protect themselves, banks should carefully match the maturity of their loans with that of their loan-able resources and apply measures to protect their loan portfolio from potential risk losses.

Input and output price volatility are important sources of market risk in agriculture. Prices of agricultural commodities are extremely volatile. Output price variability originates from both endogenous and exogenous market shocks. Segmented agricultural markets will be influenced mainly by local supply and demand conditions, while more globally integrated markets will be significantly affected by international production dynamics. In local markets, price risk is sometimes mitigated by the “natural hedge” effect in which an increase (decrease) in annual production tends to decrease (increase) output price (though not necessarily farmers’ revenues). In integrated markets, a reduction in prices is

generally not correlated with local supply conditions and therefore price shocks may affect producers in a more significant way. Another kind of market risk arises in the process of delivering production to the marketplace. The inability to deliver perishable products to the right market at the right time can impair the efforts of producers. The lack of infrastructure and well-developed markets make this a significant source of risk in many developing countries. (World Bank Report 2005)

Price uncertainty due to market fluctuations is particularly severe where information is lacking and where markets are imperfect, features that are prevalent in the agricultural sector in many developing countries (Ellis, 1988). The relatively long time period between the decision to plant a crop or to start a livestock enterprise and the realisation of farm output means that market prices are unknown at the moment when a loan is granted. This problem is even more acute for perennial tree crops like cocoa and coffee because of the gap of several years between planting and the first harvest. These economic risks have been particularly noticeable in those countries where the former single crop buyer was a parastatal body. These organisations announced a buying price before planting time. Many disappeared following structural adjustment reforms and privatisation of agricultural support services. Private buyers rarely fix a blanket-buying price prior to the harvest, even though various inter-linked transactions for specific crops have become more common today. These arrangements almost always involve the setting of a price or a range of prices, prior to crop planting. (Klein, B., Meyer, R., Hannig, A., Burnett, J., Fiebig, M 1999)

One way producers have traditionally managed price variability is by entering into pre-harvest agreements that set a specific price for future delivery. These arrangements are known as forward contracts and allow producers to lock in a certain price, thus reducing risk, but also foregoing the possibility of benefiting from positive price deviations. In specific markets, and for specific products, these kinds of arrangements have evolved into futures contracts, traded on regulated exchanges on the basis of specific trading rules and for specific

standardised products. This reduces some of the risks associated with forward contracting (for example, default). A further evolution in hedging opportunities for agricultural producers has been the development of price options that represent a price guarantee that allows producers to benefit from a floor price but also from the possibility of taking advantage of positive price changes. With price options, agents pay a premium to purchase a contract that gives them the right (but not the obligation) to sell futures contracts at a specified price. Price options for commodities are regularly traded on exchanges but can also be traded in overthe-counter markets. Futures and options contacts can be effective price risk management tools. They are also important price discovery devices and market trend indicators.

For agricultural producers in developing countries, access to futures and options contracts is probably the exception rather than the rule. However, futures and options markets in developed countries represent important price discovery references for international commodity markets and indirect access to these exchange-traded instruments may be granted through the intermediation of collective action by producer groups such as farmer cooperatives or national authorities.8 While futures and options are an important reality for some commodities, they are not available for all agricultural products. (World Bank Report 2005)

Freer trade and exposure to world markets increases price risks for farmers, especially in countries that are price takers in international markets. This will vary between commodities. For example, relatively small world markets with few exporting countries (rice) may experience more price volatility than markets which trade a fairly large portion of the domestic crop production of a larger number of producing countries (wheat). Moreover only the largest farmers have access to risk management instruments such as options. (Roberts, R.A.J and Hannig, A 1998)

When risks are nearly 100 percent correlated, futures exchange markets have emerged to allow many buyers and sellers of the risk to share risk in an organised fashion. These markets have allowed participants to protect common or correlated risks such as changing commodity prices, interest rates, and exchange rates. Futures markets have a much longer history of successful use than many of the ideas presented in this paper. Thus, less time will be spent explaining these markets. Despite well-functioning futures markets, because of the complexity of and the size needed to participate in futures markets, intermediaries are needed to facilitate participation in something that looks much more like direct price insurance. The World Bank has been working with investment banks and with the International Finance Corporation (IFC) to offer something that is much more akin to price insurance or an Asian put option. If the domestic price is highly correlated with a futures market price, it is possible to offer such contracts to local users in a developing country. The buyer (such as a RFE) would pay a premium for the right to obtain price protection at some level. For example, if the world price of coffee is trading at 40 cents, the RFE could purchase an option or insurance that would pay anytime the world price of coffee drops below 30 cents. The payment would be made in such a fashion as to make up the difference between the new lower world price and the 30-cent level. By packing various size contracts, the investment bankers and IFC hope to make these types of contracts more accessible to a wide array of users. Kenyan coffee is used in this paper as a case that may fit the necessary condition that domestic price be highly correlated with an internationally traded exchange market.

Mismatching the term of loan assets and liabilities exposes a financial institution to high liquidity risks. Good liquidity management requires priority attention in agricultural lending. The liquidity position of agricultural lenders is affected, in particular, by agricultural seasonality. Careful liquidity management is also needed in the event of large changes in agricultural commodity prices, or natural disasters. Under these circumstances withdrawals of rural savings and new loan demand of farmers occur at the same time. Agricultural lenders need reliable information on the timing of required loan disbursements and scheduled loan

repayments to properly plan and manage their cash requirements. Sufficient funds should be available at the beginning of the planting season, while the high costs of keeping loan-able funds idle should be minimised as much as possible.

Ensuring liquidity and adequate cash flow is the same as ensuring the farm's ability to survive shortfalls in net income relative to various cash obligations. Assets classified as current on the balance sheet are assets that can be converted into cash within one operating cycle of the farm business, usually 12 months. Liquid assets include instruments that yield cash directly or that can be converted quickly to cash. Liquid assets include cash on hand, supplies, and crops and livestock to be sold within the year.

Adequate liquidity is essential to ensure a sufficient cash flow. Also, adequate liquid reserves can facilitate contingency plans for production disasters or poor market conditions. However, excess liquidity typically generates lower rates of return than fixed assets.

Timing is critical for ensuring adequate cash flows. With proper planning of expenses, cash flow needs can be known with reasonable certainty. This allows you to plan marketing decisions in advance and to take advantage of attractive pricing opportunities. Improving liquidity to ensure adequate cash flows can include reducing family living expenditures, using resources efficiently, leasing assets, and utilising appropriate insurance programs.

Agricultural lending implies high liquidity risks due to the seasonality of farm household income. Surpluses supply increased savings capacity and reduced demand for loans after harvest and deficits reduce savings capacity and increase demand for loans before planting a crop. Also, agricultural lenders face particular challenges when many or all of their borrowers are affected by external factors at the same time. This condition is referred to as covariant risk which can seriously undermine the quality of the agricultural loan portfolio. As a result, the provision of viable, sustainable financial services and the development of a strong rural

financial system is contingent on the ability of financial institutions to assess, quantify and appropriately manage various types of risk

Most small farmers and other rural entrepreneurs, due to their dispersed location and the general poor rural infrastructure, experience great difficulty in accessing urban-based banks. Rural client dispersion and small loan volumes lead to high financial transaction costs both for banks and borrowers, and increase the perception of high risks which banks usually associate with small rural clients. In addition, current bank practices and procedures may discourage rural clients from using formal financial services and, in many cases, rural people are even unaware of the availability of financial services or of the conditions under which these are available. Moreover, small farmers have to make many visits to banks at office hours which may not be convenient to them, while banks lack essential information on the credit history of potential clients, the viability of on-farm investments, the self-financing capacity of farmers and their repayment capability.

Transaction costs in rural areas are high compared to urban areas, due to problems of collateral provision, low and irregular income flows and the small amounts involved in the transactions. Three types of borrower have been identified transaction costs: non-interest charges by lenders; loan application procedures that require the applicant to deal with agents outside the banking system, such as agricultural extension staff, local officials and co-signers; and travel expenses and time spent promoting and following up the application (Von Pischke, 1991). Due to these factors the costs of reaching the rural poor and small-scale farmers are high for financial institutions, which charge high interest rates when compared to market rates in the formal banking sector. The overall costs of formal borrowing therefore, in many cases, may result in borrowing from the informal sector becoming more attractive to small-scale farmers. The challenge still remains to design and expand the provision of loan products to better service the farming community and to lower transaction costs to improve the terms and conditions of lending for agriculture. This will demand improved management of existing rural

financial intermediaries, and innovations or ‘new methods’ in financial intermediation for the agricultural sector.

Banks may decide to open rural branches, but the demand for bank services needs to be large enough to warrant setting up such a rural branch network. Efforts to expand the range of financial services by including savings mobilisation and current accounts may lead to economies of scale and thus to higher efficiency. Simplification of loan procedures may minimise the travel time and costs for individual borrowers, while group lending based on joint and several liability of group members and liaison with NGOs are other means of reducing costs. In all cases, the availability of decentralised financial intermediation services is a precondition for effective on-farm lending. (Roberts, R.A.J and Hannig, A 1998) Low population density coupled with dispersed location of rural clients make the provision of formal financial services costly. From the lender’s perspective, the long distances between communities and the inadequate rural transportation facilities in many developing countries increase the costs of loan appraisal, loan monitoring and enforcement of loan repayments (Gurgand, et al. 1996). The use of mobile loan officers and/or branch offices can be effective in lowering transaction costs. But mobile facilities may be subject to security risks if bank staff is required to transport money. The establishment of a rural branch network reduces the security risks, but branches are costly to maintain and to supervise.

Financial transaction costs of institutional credit can also be high for rural borrowers. This results from the high opportunity costs of lost working time. A borrower may have to pay several visits to the bank branch office to conclude cumbersome loan application procedures which require a long time for processing. Clients often have to spend much time and money to obtain the required documents and to find loan guarantors. For very small loans, these costs can significantly increase the effective lending interest rate (Klein, 1996). While the decentralisation of field operations has been effective in reducing the transaction costs in some countries their success depends on the local

environment, infrastructure conditions and the management skills of the financial institution.

Potentially serious risk problems have raised from the effects of failed directed credit programmes. The impact on the loan repayment discipline is pervasive. Borrowers who have witnessed the emergence and demise of lending institutions, have been discouraged from repaying their loans. Further people have repeatedly received government funds under the guise of “loans”. Loan clients have been conditioned to expect concessional terms for institutional credit. Under these circumstances, the incidence of moral hazard is high. The local “credit culture” is distorted among farmers and lenders. Borrowers lack the discipline to meet their loan repayment obligations, because loan repayment commitments were not enforced in the past. Lenders, on the other hand, lack the systems, experience and incentives to enforce loan repayment. There is also an urgent need to change bank staff attitudes and the poor public image of financial institutions in rural areas.

Another effect of a distorted credit culture on the risk exposure of agricultural lenders is the priority that borrowers give to repaying strictly enforced informal loans. These are settled before they comply with the obligations associated with “concessional” institutional credit. This is explained by the fact that losing the access to informal credit is viewed as more disadvantageous than foregoing future bank loans (due to the uncertain future of rural financial institutions). Very often informal lenders have stronger enforcement means than banks.

Farmers always know more about their yield potential and risk than anyone from the outside (either the government or a private insurer). Such asymmetry in information creates the dual problems of adverse selection and moral hazard. Adverse selection occurs when there are problems in classifying risk of potential purchasers. Because farmers know the most about their potential yields, they will look at the insurance offer and decide if it is fair or maybe even more than fair. Those who conclude that it is more than fair will buy. Those who conclude it is overpriced for their risks will stay out. (Seeks, R. J. 2003)

Policy changes and state interventions can have a damaging impact on both borrowers and lenders. For the latter they can contribute significantly to covariant risks.

Many low-income economies under structural adjustment programmes

have slashed their farming subsidies. This has had, for instance, a serious effect on the costs and the demand for fertiliser. Reducing government expenditures as an essential part of structural adjustment programmes may also affect employment opportunities in the public sector. Costs may even reduce agricultural production levels, if extension services are suddenly discontinued.

Policy makers should also carefully consider the structural characteristics of agriculture for different countries. In general, farms in developing countries are significantly smaller than farms in countries like the United States and Canada. For traditional crop insurance products, smaller farms typically imply higher administrative costs as a percentage of total premiums. A portion of these costs are related to marketing and servicing (loss adjustment) insurance policies. Another portion is related to the lack of farm-level data and cost effective mechanisms for controlling moral hazard.

When making decisions about agricultural risk management programs, policy makers face a number of constraints. They must consider whether the benefits of such programs outweigh the costs, and if so, outweigh the net benefits offered by competing demands on public resources. They must construct the risk management program so as to minimise distortions in resource allocation and reduce opportunities for rent-seeking behaviour. They must take into consideration the status and development of financial and insurance institutions within the country, any regulatory constraints on the operations of those institutions, and the infrastructure for enforcing contracts. Finally, it is important to consider the dichotomy that exists in many countries between smallholder farms and large farms that produce for export markets.

Policy makers often suggest agricultural insurance programs as an alternative to free ex post disaster assistance. In principle, insurance programs have many advantages over ex post disaster assistance. For example, it is often argued that disaster assistance programs can generate perverse incentives that increase the magnitude of losses in subsequent disaster events (Barnett 1999; Rossi et al. 1982). But, in practice, agricultural insurance programs have often evolved into another vehicle for transferring wealth from the public sector to agricultural producers. Furthermore, there is not much evidence that agricultural insurance programs have been successful in forestalling free ex post government disaster assistance. For example, in the United States, more and more costly crop insurance programs have coexisted with disaster payments for well over 20 years (Glauber 2004).

Given limited resources in developing countries and the existence of other sectors that require government attention, these objectives are typically pursued within an environment of binding fiscal constraints. These objectives target different segments of people in rural areas and different risk profiles. Growth objectives focus on increasing profitability so that less poor farmers can continue adopting production technologies even when high-frequency, low consequence loss events occur. Poverty reduction policies target the poor and seek to increase their average income, and decrease the volatility of their income and the likelihood of a risk event wiping out hard-won asset gains.

Developing countries also have far less access to global crop reinsurance markets than do developed countries. Reinsurance contracts typically involve high transaction costs related to due-diligence. Reinsurers must understand every aspect of the specific insurance products being reinsured (for example, underwriting, contract design, ratemaking, and adverse selection and moral hazard controls). Some minimum volume of business, or the prospect for strong future business, must be present to rationalise incurring these largely fixed transaction costs. The enabling environment to gain confidence in contract enforcement and

the institutional regulatory environment are critical to create trust that must be present for a global reinsurer to become involved. These components are largely missing in developing countries. In fact, a prerequisite for effective and efficient insurance markets is an enabling environment. Setting rules assuring that premiums will be collected and that indemnities will be paid is not a trivial undertaking.

There are various reasons for developing countries to avoid adopting approaches to risk management similar to the ones adopted in developed countries. Clearly, developing countries have more limited fiscal resources than developed countries. Even more importantly, the opportunity cost of those limited fiscal resources may be significantly greater than those of a developed country. Thus, it is critical for a developing country to consider carefully how much support is appropriate and how to leverage limited government dollars to spur insurance markets. In developed countries, government risk management programs are as much about income transfers as they are about risk management. Developing countries cannot afford to facilitate similar income transfers to large segments of the population who may be engaged in farming. Nonetheless, since a larger percentage of the population in developing countries is typically involved in agricultural production or related industries, catastrophic agricultural losses will have a much greater impact on GDP than in developed countries.

CHAPTER: 3

RISK AND RISK MANAGEMENT 3.1 RISK: Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event.

Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organisation may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc, it is believed that generally the banks face Credit, Market, Liquidity, Operational, Compliance / legal / regulatory and reputation risks.

Financial risk is often defined as the unexpected variability or volatility of returns, and thus includes both potential worse than expected as well as better than expected returns.

Financial risk in a banking organisation is possibility that the outcome of an action or event could bring up adverse impacts. Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives. Such constraints pose a risk as these could hinder a bank's ability to conduct its ongoing business or to take benefit of opportunities to enhance its business.

Regardless of the sophistication of the measures, banks often distinguish between expected and unexpected losses. Expected losses are those that the bank knows with reasonable certainty will occur (e.g., the expected default rate of corporate loan portfolio or credit card portfolio) and are typically reserved for in some manner. Unexpected losses are those associated with unforeseen events (e.g. losses experienced by banks in the aftermath of nuclear tests, Losses due to a

sudden down turn in economy or falling interest rates). Banks rely on their capital as a buffer to absorb such losses.

3.2.1 SYSTEMATIC RISK: Systemic risk describes the likelihood of the collapse of a financial system, such as a general stock market crash or a joint breakdown of the banking system. As such, it is a type of "aggregate risk" as opposed to "idiosyncratic risk", which is specific to individual stocks or banks.

2.2.2 NON SYSTEMATIC RISK: Systemic risk should be carefully distinguished from non-systemic risk, which describes risks which the whole economy faces such as business cycles or wars. Since systematic risk is caused by factor that affects the whole economy or whole market therefore it is not possible to be controlled by a person.

3.2 RISK MANAGEMENT: Risk management is a rapidly developing discipline and is a central part of any organisation’s strategic management. Risk management evaluates which risks identified in the risk assessment process require management and selects and implements the plans or actions that are required to ensure that those risks are controlled. The focus of good risk management is the identification and treatment of these risks.

In ideal risk management, a prioritisation process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in

descending order. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled.

Intangible risk management identifies a new type of risk - a risk that has a 100% probability of occurring but is ignored by the organisation due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a knowledge risk materialises. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity.

3.3 RISK MANGEMENT PROCESS: Risk management should be a continuous and developing process which runs throughout the organisation’s strategy and the implementation of that strategy. It should address methodically all the risks surrounding the organisation’s activities past, present and in particular, future.

Risk management is the process of measuring, or assessing, risk and developing strategies to manage it. Strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk

3.3.1 RISK IDENTIFICATION: The first step in risk management is identification of risk. Risk identification can start with the source of problems or with the problem itself. The source may be internal or external to the system or organisation.

3.3.2 RISK ASSESSMENT:

Once risks have been identified, they must then be assessed as to their potential severity of loss and to the probability of occurrence. These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely event occurring. Therefore, in the assessment process it is critical to make the best educated guesses possible in order to properly prioritise the implementation of the risk management plan. Risk assessment involves identifying sources of potential harm, assessing the likelihood that harm will occur and the consequences if harm does occur.

The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical information is not available on all kinds of past incidents. Furthermore, evaluating the severity of the consequences (impact) is often quite difficult for immaterial assets. Asset valuation is another question that needs to be addressed. Thus, best educated opinions and available statistics are the primary sources of information. Nevertheless, risk assessment should produce such information for the management of the organisation that the primary risks are easy to understand and that the risk management decisions may be prioritised.

3.4 POTENTIAL RISK TREATMENTS: Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories. •

Retention

•

Mitigation

•

Elimination

•

Transfer

Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are not acceptable to the organisation or person making the risk management decisions.

Figure 3.1 Risk Treatment

Severity of Risk

Frequency of Risk Low

High

Small

Retention

Mitigation

Large

Transfer

Elimination

3.4.1 RISK ELIMINATION:

Includes not performing an activity that could carry risk. An example would be not buying a property or business in order not to take on the liability that comes with it. Another would be not flying in order not to take the risk that the aeroplanes were to be hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting

(retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.

3.4.2 RISK MITIGATION:

Involves methods that reduce the severity of the loss. Examples include sprinklers designed to put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water damage and therefore may not be suitable. Fire suppression systems may mitigate that risk, but the cost may be prohibitive as a strategy.

3.4.3 RISK RETENTION:

Involves accepting the loss when it occurs. True self insurance falls in this category. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible. War is an example since most property and risks are not insured against war, so the loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over the amount insured is retained risk. This may also be acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals of the organisation too much.

3.4.4 RISK TRANSFER:

Risk transfer means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to another party without the payment of an insurance premium. Liability among construction or other contractors is very often transferred this way. On the other hand, taking offsetting positions in derivatives is typically how firms use hedging to financially manage risk. Some ways of managing risk fall into multiple categories. Risk retention pools are technically retaining the risk for the group, but spreading it over the whole group involves transfer among individual members of the group. This is different from traditional insurance, in that no premium is exchanged between members of the group up front, but instead losses are assessed to all members of the group.

3.5 LIMITATIONS: If risks are improperly assessed and prioritised, time can be wasted in dealing with risk of losses that are not likely to occur. Spending too much time assessing and managing unlikely risks can divert resources that could be used more profitably. Unlikely events do occur but if the risk is unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss does in fact occur. Prioritising too highly the risk management processes could keep an organisation from ever completing a project or even getting started. This is especially true if other work is suspended until the risk management process is considered complete.

CHAPTER: 4

ANALYSIS

Agricultural finance is faced with many challenges and the most severe challenge is that of risk management.

There are a number of risks associated with

agricultural finance. In the literature review of the report some of the risks have been highlighted and analysed by different researchers.

In this section the risk associated with agricultural finance are analysed by using fishbone diagram or cause-and-effect analysis.

4.1 CAUSE-AND-EFFECT ANALYSIS: Cause-and-effect analysis is a systematic way of looking at the effects and causes of a problem.

In this technique the relationship between dependent and

independent variable is determined through a diagram. The diagram drawn for this purpose is called “Fishbone Diagram”. The name is because of its shape that is like skeleton of a fish. Dr. Kaoru Ishikawa, a quality control statistician of the University of Tokyo developed and it was first used in 1960s. Therefore sometimes it is also called “Ishikawa Diagram”.

Since Ms. Jennifer Isenhour has used this analysis technique in her research “ Cause and Effect Analysis of Risk Management to Assess Agricultural Finance” (2004) therefore the same analysis technique is also used for the present research to look at the different risks associated with agricultural finance affecting the overall profitability of agricultural lending institution.

Figure 4.1 Fishbone Diagram

Liquidity Risk

Market Risk Seasonality of agricultural crops

Lower offer price for crop Entry of big external players

Untimely rains or droughts Lack of crop insurance concept

Limited amount of savings

Profitability of Agricultural lending institution

Dispersed rural clientele High servicing cost

Weather Risk

Operational Risk

The diagram shows different risk categories affecting the profitability of agricultural lending institutions. Different factors cause a specific risk, which then affect the profitability of an agricultural lending institution.

4.2 CAUSES OF LIQUIDITY RISK: Liquidity risk occurs because of agricultural crops’ seasonality. At the cultivation period farmers borrow from institutions for meeting their funds requirements for purchase of seeds, fertilisers, pesticides and labour etc and thus the institution faces with short of funds while in the harvesting season when the farmers repay their loans, the institutions are in excess liquidity which cause them liquidity risk. And another reason of liquidity risk is that of lack of saving and deposits with the

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

4.3 CAUSES OF OPERTIONAL RISK: The people related to agriculture are mostly spread over a vast area in far away villages. The dispersed agricultural clients cost the bank with higher operational risk. When a bank want to serve clientele spread over large area or when most of loan amount is small which is often there in developing country like Pakistan then it causes the bank with higher servicing costs which result in operational risk. The bank does not earn that much as it spend on processing, disbursement and monitoring of agricultural loan.

4.4 CAUSES OF MARKET RISK: Market risk occurs when the farmer gets a lower offer price for their finished products in the market than the cost incurred on producing that crop. This causes a farmer suffer losses as he is not earning that much to repay his loan and eventually this risk is transferred to the lending institution in form of nonperforming loan. When new external players enter into the market with greater volume and capital then it results in problems for local farmers. The local farmer produce at small volume and occupies a small share in the market but when a new player with huge volume enters into the market then he captures the whole market and the small farmer cannot survive.

4.5 CAUSES OF WEATHER RISK: Weather risk is a unique risk involved in agriculture that does not effect other sectors as much as it affects this sector. Untimely rains, floods, droughts destroy

the crops and result in potential loss to the farmer. Different diseases in animals can bring potential losses to the farmer-borrower. As in recent time due to bird flu many poultry farms suffered losses and subsequently the institutions who lend to them also faced many problems in get their loans paid back. This risk can only be minimised by taking preventive measures. Crop insurance can be a useful tool in this regard but is not common in developing country like Pakistan.

4.6 THEIR EFFECT: All these risks individually and collectively have negative effect on the profitability of an agricultural financial institution. The weather risk, market risk minimises the return on loans while the operational and liquidity risk increase the cost of disbursement loans.

Figure 4.2: Effects on Profitability

Return of loans Cost on loans

4.7 AGRICULTURAL CREDIT DELIVERY

Agricultural Credit Requirement & Disbursement by Institutions The table shows the agricultural

Year

Requirement Rs in million

credit requirements and disbursement by institutions. There is a continuos increase in the demand for agriculture credit while the supply of credit is not increasing at the same rate.

The same figures are plotted on a

1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01

31952 39338 45636 52694 62202 68569 78451 102570 120000 136740 145860

Disbursement Rs in million 15207 14906 16896 16243 22941 19774 19515 32984 42847 39688 44043

Source: Journal of Institute of Bankers Pakistan

graph for graphical representation and we can see the credit requirement curve is on increase while the credit disbursement curve is not following it.

Figure 4.3

During the whole decade the requirement for agricultural credit are consistently increasing. The reason is the increasing population of the country needs more food and dairy products which of course agriculture sector is producing. Farmers need resources for production. The problem is that this increasing demand for credit is not accompanied by supply of credit at the same rate. This is another challenge for agriculture finance in agricultural credit delivery.

CHAPTER: 5

RECOMMENDATIONS The agricultural credit institutions, to protect themselves from risks, should classify the agricultural sector in terms of risk. The activities with higher loan default rate because of any reasons should be kept in high-risk zone and activities with lower loan default rate should be placed in low-risk zone. The financial institution should first start lending in low-risk zones and then gradually go towards high-risk zones.

Financial supervision should be strengthened and financial institutions should keep provisions for loan losses higher than that of other sectors because agriculture business is comparatively more risky. In this way institutions can protect themselves against credit risk associated with agricultural finance.

The mind-set of borrowers also needs to be changed. The habitual defaulters should be discouraged to get the loan or if disbursed then default. This mostly happens in situations where the borrower does not use the loan amount for the purpose he has acquired for. So the actual situation should be clear to the lender by visiting and monitoring.

Diversification has always been a strategy to minimise risk.

The same

diversification strategy should be adopted in agricultural finance and loan should be disbursed to different activities of agriculture e.g. in farm business, non-farm business, live stock etc. In this case if the borrower suffer losses in one side then he would be earning profits on other side and would be able to repay his loan.

Similarly the repayment schedules should also be classified in such a way that is convenient for individual borrower to repay his loan in easy instalments. This will minimise the credit risk.

For minimising credit risk, information database should be there with the lender about the credit history and credit worthiness of farmer-borrowers to help in loan disbursement.

Appropriate collateral should be taken to minimise the risk of default in loans. In this respect warehouse receipt is very appropriate. The warehouse receipt will help farmer-borrower to use it as collateral in getting loan for agriculture purpose.

The market risk should be minimised by promoting diversified sources of income for rural household so that if farmer suffer losses by selling his produced at lower offer prices then he would be able to repay the loan from his other sources of income.

Crops are mostly destroyed because of bad weather conditions or diseases that cause the farmer losses. Crop insurance in this prospect is an excellent idea to protect crops from unfavourable weather conditions.

In meeting the demands of international markets, farmers will need to produce commodities according to international standards and qualities. Significant changes in the production structure may be required in terms of enterprise choice and the degree of specialisation, adjustments in farm size and integration of farm production with farm input supply, agro-processing and marketing in the same commodity chain. Such changes are easier for large rather than small farmers.

CONCLUSION Agriculture sector is Pakistan is growing at upward trend because of increasing population and this result in increase for credit needs by farmers for the their agriculture activities but the credit disbursement by banks is not increasing at the same rate to meet the farmers requirements.

Agriculture is a risky business. Both agricultural specialised financial institutions and agricultural credit departments of commercial banks are greatly affected by this and cause them with greater number of non-performing loans and lower profit margin.

Agricultural lending projects have comparatively poor repayment performance mainly because of the reason that agriculture business have greater exposure to weather risk. Market and price are additional risks that are associated with agricultural finance.

Market and price risks are associated with agricultural

finance in the way that many agricultural markets are imperfect that lacks communication infrastructure and access to the market. It cost a farmer higher to take his crops to the market because of bad condition of roads, lack of information and thus result them higher cost of the crops while they have to sell in the market at competitive price.

In pure perfect market where international players freely enter into the local market can ruin the local agriculture industry and cause local farmers difficulty in repayment f their debts because of greater and powerful competition.

Operational risk is associated with agricultural finance in the sense that in case of small farmer-borrowers spread over vast area, cost higher to serve. The cost of servicing customers is higher than the profit earned from them. The financial institutions face with liquidity risk in different seasons. In the cultivation season, the financial institution faces with shortage of funds to lend out while after the harvesting season, the financial institutions have excess of liquidity.

Credit risk associated with agricultural finance is influenced by cost and interest rate margin. The financial institutions are also greatly influenced by political interference especially in case of state-owned financial institution. Loan writeoffs increase the cost of lending for the financial institution.

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