The environment for rural financial intermediation has changed significantly in recent years with an enhancement of the role of markets and increased privatization in most developing countries. However, an immediate result of most of these reforms has been that fewer small farmers and other rural households qualify for credit or that those who do qualify will have to pay more for loans. At the same time, in view of the high proportion of the population engaged in agriculture in developing countries and the strategic importance of (in particular) basic food production, policy makers are highly sensitive to public interventions in favour of the farmer population. It is vital, however, that financial institutions are not “misused” to fulfil social equity purposes and that public interventions in this direction, while fully justified, are obtained through alternative mechanisms.
A principal aim of financial sector reform is to ensure that market-based and a varied supply of financial services (financial widening) are available to an increasing number of both commercial farmers and farm households, agriprocessors, traders and other rural non-farm entrepreneurs (financial deepening). To achieve these objectives will require a good understanding of rural economics, the existence of an appropriate policy and legal framework for rural finance and access to financial as well as to non-financial support services. Together with the need for an appropriate policy and legal framework and appropriate rural financial structures, it is important to discuss the unique features and special needs of agricultural production and agricultural finance. Thus government policy makers, inter-national development agencies and bankers focus on the following specific agriculture-related issues:
- The high financial transaction costs of attending dispersed and small farm households;
- The seasonality and the importance of opportune timing of on-farm finance for cultivation practices, input application, harvesting (and related output marketing), the heterogeneity in farmers lending needs (seasonal and term lending) and the relative long duration of agricultural lending contracts;
- The dependence on sustainable natural resources management and the relative low profitability of on-farm investments;
- The various weather and other production risks, together with marketing risks related to agriculture, that require appropriate risk management techniques, both for producers and financial intermediaries;
- The limited availability of conventional bank collateral that farm households can offer, that highlights the need to increase the security of existing loan collateral or develop appropriate collateral substitutes;
- The reality that farm households are confronted with emergency needs and that their loan repayment capacity is highly dependent on consumption and social security contingencies;
- The need for adequate training of both bank staff and farmer clients.
Access of small farmers to financial services
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 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. There are three types of borrower 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 cosigners; and travel expenses and time spent promoting and following up the application. 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 mobilization and current accounts may lead to economies of scale and thus to higher efficiency. Simplification of loan procedures may minimize 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 decentralized financial intermediation services is a precondition for effective on-farm lending.
Heterogeneity, seasonality and duration of on-farm lending
Individual farmers have different investment needs, and may apply for seasonal and/or investment loans to meet specific financing requirements. For example, a livestock enterprise may require financing of land improvements (fencing and water), buildings to house the animals, purchase of animals (breeding stock), animal feed, crop production and other operational production costs (labour, machinery, veterinary costs). Further, each of these expenses occurs at a different time and, in accordance with the enterprise revenues and cashflow, requires a specific repayment schedule. For example, milk production has a relatively constant revenue stream and cash flow, while beef production experiences only periodic sales. Crop expenses are incurred for land preparation and planting and continue through cultivation, harvesting, storage and marketing, while income revenues generally occur only at the time of crop selling and are often received in one lump sum. Diversification of farm enterprises and off-farm income contribute to smoothing out farm household expenditure requirements and income flows. Indeed, the cashflow at farm household level is greatly influenced by the heterogeneity of production, trading and consumption and social security transactions within the household.
Timely availability of farm inputs such as seed and fertilizer, in accordance with cultivation practices, is essential in farming, and requires flexible financing mechanisms. In particular, non-permanent working capital requirements may be ideally met by a bank overdraft or a special credit line for working capital, which has the potential to reduce transaction costs for both the client and the bank. However, it requires that the banker knows his client well and has sufficient confidence in the farmer’s management capabilities. In particular, in the case of investment loans, banks require good investment loan appraisal studies and timely and accurate farm records. Banks should also be in a position to supervise the execution of the investment/financial plan. Training of farmers and bank staff in preparing and evaluating farm plans as well as in loan follow-up constitutes an important technical assistance function that may be provided by donors and/or governments, without violating the principles of free markets, by respecting the autonomous decision power of financial intermediaries in providing loans for viable on-farm investments. Encouragement of savings and building up the financial reserves of farmers will strengthen their self-financing capacity. Complementary bank credit may be useful in particular to finance increased working capital and new capital investments, while leasing financial arrangements may be attractive for the acquisition of farm machinery and similar ‘lumpy’ investments.
Profitability and risks of on-farm investments
The major factors that affect banker and farmer behaviour in on-farm lending operations are the expected profitability of and the risks related to on-farm investments. 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 utilization of financial resources and the repayment behaviour of farmer clients. The relative importance of these different risks will vary by region and by type of farmer. For example, marketing risks are greater for mono-crop cultures in developing countries, which depend on volatile world markets. These risks will also decrease as the level of education of farmers and the availability of information on markets, prices and loan repayment behaviour increase. In some cases, especially for relatively high technology farming that involves significant investments, agricultural insurance may be useful as a risk management tool. But it should be used only for specific crop/livestock enterprises and for clearly defined risks.
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 loanable 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 loanable resources and apply measures to protect their loan portfolio from potential risk losses.
Additional risk protection measures that present added costs to borrowers include insurance coverage against insurable risks such as specified adverse weather events leading to crop damage (as noted above) or insurance against fire (buildings and crops) and theft (movable assets). Government or donor-financed loan guarantee schemes, in general, have not led to significantly increased bank lending (additionality) and they should be carefully designed in order to secure appropriate risk management and sharing as well as a cost effective administration. On the other hand, mutual guarantee associations have proven their usefulness.
Banks also control their financial exposure by limiting their loans to only a portion of the total investment costs and by requiring that the borrower engages sufficient equity capital as well as by a careful diversification of their loan portfolio in terms of lending purposes, market segments and loan maturities. It is worth underlining that successful (micro) financial institutions operating in rural areas, especially densely populated rural areas, do not concentrate their portfolio in agriculture to the exclusion of non-farm activities. This is because portfolio diversification is a key to sustainability and successful risk management.
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 often supplementary collateral are sometimes accepted by banks, such as third party guarantees, warehouse receipts and blocked savings. Without secure loan collateral, it is expected that there will be a contraction in the supply of bank credit and this will result in reduced access of small farmer and rural clients to finance.
In the informal credit market, where intimate client knowledge and, often, inter-linked trade/credit arrangements exist, non-tradable assets or collateral substitutes, such as reputation and credit worthiness, are much more prominent. Group lending based on group control and joint and several liability of group members, and group savings are suitable forms of collateral substitutes. These are increasingly used by donors and NGOs. It may be effective if groups are homogenous in their composition, interests and objectives and when problems of moral hazard can be avoided. However, in many countries, groups of farmers do not easily meet these criteria. In addition, also due to the long duration of agricultural loans and high costs of group training, individual lending in agricultural finance, in general, is much more widespread and might be more appropriate than group lending. Moreover, successful experience with group lending is chiefly for non-agricultural purposes.
Emerging successful microfinance institutions have built up their loan portfolio following a modern “credit technology”. Modern credit technologies targeted at a resource poor clientele assign greater importance to keeping risks in check (e.g. by maintaining loan amounts small and of short duration) and to well designed repayment incentives. One of the most powerful incentives to loan repayment is the prospect of access to subsequent loans. Thus, the typical loan disbursed by these institutions is for a short term (4 – 12 months), and loan amounts start small and grow slowly in accordance to a client’s repayment performance. With regard to agricultural finance, such modern “credit technology” may be suitable to livestock farming, where the cash-flow generated is more continuous. However, this is not the case with crop production as the extent to which new credit technology may be utilised is inversely dependant upon the importance of crop sales on family income.
From numerous expert reports and meeting documents it is evident that agricultural credit expansion is hampered by farmers’ lack of knowledge about the availability and conditions of credit, and by the shortage of well trained bank staff, who have experience in dealing with small farmers and rural people. Training therefore should focus both on bank staff and farmers clients.
Banks’ field staff should have appropriate education and training in business and farm management, agriculture and banking. In their work they should interact closely with agricultural extension agents and organisations, who provide essential non-financial support services to small farmers and rural people. Such liaison should involve sensitizing farmers about the availability and conditions of bank credit and assist farmers in preparing proper farm and business plans and submitting loan applications. Extension agents and similar technical staff, however, should not be involved in loan approval and loan recovery, which remains the exclusive task of banks.
Banks should accept staff training as an investment, forming part of overall manpower development. This needs to be reflected when recruiting staff, bearing in mind that poor recruitment practices may result in poor recruits which cannot be easily rectified by training.
Measures should also be taken to provide adequate incentives to bank staff who work in rural areas. Salary levels and fringe benefits, compensation for overtime work, appointment and career perspectives need to be in line with similar employment in the urban sector in order to promote agricultural lending.
The main objective of farmer training should be to increase the benefits of borrowing for production purposes and should be oriented at improving the business skills of individual farmers. Topics to be included are farm planning and farm management, risk management, book keeping and cost accounting, savings and liquidity management, the role and use of credit, the costs of credit (interest and related financial charges), collateral requirements, loan repayment obligations, legal measures against loan defaulting, etc. Such training can be prepared by banks and delivered to the farmers in conjunction with or by agricultural extension staff. Grassroots groups, member-owned financial intermediaries such as credit and savings associations and co-operatives require a more specialized type of training in group organization, joint liability, financial and business management, savings mobilization and protection, assessment of investment profitability and risks, building up of capital reserves, lending procedures, accounting and management information systems.
Agricultural bank staff and private sector business or NGOs may provide essential training support to initiating groups, when the requirements of training are greatest and when additional costs are the least affordable. Non-financial services such as information, training and extension can be provided by the state, by the private sector or by a combination of these. The problem is finding the right combination and identifying how to institutionalize these arrangements. Many drawbacks in the provision of support services in developing countries can be traced to their high costs, to inefficiency and to non-involvement or non-commitment of the final beneficiaries, when they are provided directly by the public sector.The private sector strengths are in identifying the immediate needs of different clientele, in organizing the supply of services to meet the demand, and in managing effectively the financial transactions involved. However, there is still an important role for the public sector in providing a proper policy and legal environment within which private sector business activities can take place.