PART B: AGRICULTURAL TERM FINANCE IN PRACTICE

2. Brief Overview of the Case Studies

Most financial institutions are reluctant to provide term finance to farmers due to the issues discussed in chapter 1. Though the scarcity of such finance might be partly attributable to the difficulties of this field of banking and the often hostile environment, it may also point to a lack of dynamism, innovation or competition in the financial system. Under the past directed-credit paradigm, banks were forced to lend to agriculture even in an adverse economic environment and without a proper financing technology. The present financial liberalization has often led to the opposite extreme: commercial banks in several developing countries are characterized by high levels of excess liquidity, which they prefer to invest in low-risk, low-return assets such as treasury bills. Lending is often restricted to well-established medium- and largescale companies in the commercial, service and industrial sectors. Microfinance institutions, on the other hand, often concentrate their activities in urban or peri-urban areas, focusing on non-agricultural activities with a quick turnover, such as commerce and services.

Despite this bleak overall picture, there are some encouraging examples that illustrate that the problems of risk, transaction costs and asymmetric information can be overcome through an appropriate financing technology. Case studies were conducted in 2001 and 2002 in Bolivia, India, Madagascar, the Philippines, South Africa and Thailand^[18]. Moreover, experiences with agricultural term finance in Benin, Ghana, Indonesia, Kenya and Mali were analysed^[19]. Due to the scarcity of examples, simple selection criteria were chosen: casestudy institutions were to be financially viable and to use innovative approaches to term finance, in the sense of not repeating the failures of the directed-credit approach.

2.1 Features of the Institutions

The main features of the case-study institutions and their term finance portfolios are summarized in Table 4, which shows their great variety in terms of type, size and exposure to term finance. The two agricultural development banks are by far the largest and have the largest term finance portfolios, including both medium- and long-term loans. Through its 587 branches, the Bank for Agriculture and Agricultural Cooperatives (BAAC) has a national outreach. More than half its portfolio is invested in medium- and long-term loans to small- and mediumscale farmers. The Land and Agricultural Development Bank of South Africa (Land Bank) also has a large term loan portfolio, though the bulk of it is lent to medium- and large-scale, white commercial farmers. The provision of medium-term loans to black farmers is still rather limited.

The other institutions are comparatively small, with smaller term finance portfolios. They are composed of non-governmental organizations (NGOs), non-bank financial institutions (NBFIs), and mutualist FIs. Some operate in a single region - Centro de Investigación del Desarrollo Regional Económico (CIDRE) and Mulukanoor Cooperative Rural Bank (MCRB) - while most are present in several, either through branches - Caja los Andes (CLA), BASIX, Asociación Nacional Ecuménica de Desarrollo (ANED) - or a federation - Caisses d’Epargne et de Crédit Agricole Mutuel (CECAM). Most have been quite innovative in pioneering the introduction of new products and financing technologies. Only one successful example could be found of a non-financial institution providing term finance to small- and medium- scale farmers: Umthombo, formerly called the Financial Aid Fund, is a revolving fund capitalized by the South African Sugar Association. It provides medium-term loans for the establishment of plantations and the purchase of irrigation equipment.

Most case-study institutions focus on the provision of medium-term loans with maturities of three to seven years. Only the agricultural development banks and second-tier institutions such as the Land Reform Credit Facility (LRCF) are able to provide long-term loans with grace periods. With the exception of Land Bank, all case-study institutions focus on market-oriented, small- and medium-scale farmers and non-farm small and medium enterprises (SMEs). Loan sizes generally range from US$ 2 000 to 20 000, although several institutions offer larger loans for land development, buildings, specialized farm machinery and agroprocessing facilities.

Table 4
Features of the term finance (TF) portfolios

(a) end of 2002, (b) end of 2001, (c) end of 2000, (d) from May 2000 until October 2001

2.2 Motives for Engaging in Agricultural Term Finance

In view of the general reluctance of FIs to offer rural term finance, this section takes a brief look at the motivations of the case-study institutions for engaging in this activity:

• Retaining clients. Institutions with a microfinance background or mutualist FIs realized that their more advanced clients required access to larger loans with longer repayment periods, e.g. to purchase equipment. Medium-term finance allowed them to continue to service these clients. Such investments also strengthened the clients’ businesses and thus future demand for short-term loans as well.

• Servicing new clients. In several cases, market surveys revealed the existence of farmers/rural entrepreneurs with good investment opportunities, who needed term finance to buy equipment or other assets to expand their businesses. These investors were too ‘big’ for microfinance loans, but too ‘small’, or unable to offer suitable collateral, to be regarded as viable by mainstream FIs. In some countries, these farmers were the better clients of now-closed agricultural development banks and no longer had access to formal financial institutions.

• Diversifying from saturated urban markets. Some urban-based FIs such as CLA and the Rural Bank of Panabo (RBP) have faced increasing competition in urban markets for consumer and smallbusiness finance, whereas rural markets were largely underserved by formal financiers.

Ownership structures and the influence of major shareholders, institutional mission, and support from governments and donors were other driving forces in all cases.

• Shareholder influence. Owners need to have a strong commitment and long-term business strategy to enter this market. For example, the owners of RBP were willing to put a substantial amount of capital at risk to develop a viable approach to smallholder lending, despite the losses the bank had experienced in the past in this market. In the case of the mutualist RFIs MCRB and CECAM, the majority of shareholders are farmers, many of whom were willing to remain in the agricultural sector.

• Institutional mission. This is most obvious in the case of the agricultural development banks, whose core functions include the provision of medium- and long-term finance to farmers. Despite the fact that most of them have failed due to weak management and political pressure to provide loans beyond prudential banking norms, some of them have been successfully reformed - BAAC, for example. Also, some NGOs have a mandate to assist farmers in financing productive investments.

• Government and donor support. In many cases, governments have played an important role in supporting RFIs that engage in term finance. Most case-study institutions have also been supported by donors, both in terms of technical assistance and of seed capital for developing term finance products.

2.3 Performance of the Portfolios

The quality of the term finance portfolios of the case-study institutions has generally been satisfactory. The repayment rate or on-time lease payment rate of most is above 90 percent. However, in some cases the quality of the agricultural term asset portfolio is difficult to assess, because the management information system (MIS) does not generate data according to maturity or purpose. This is the case, for example, with CLA. Other institutions, such as Land Bank, have only recently moved into providing agricultural term finance to emerging commercial farmers, and they cannot supply data yet on portfolio quality. Table 5 provides the repayment rates for the institutions for which this data is available.

While BASIX and BAAC have lower repayment rates for term loans than for seasonal loans, in the case of CECAM and ANED, lease payment rates are higher than those for loans. BAAC is a particular case because of its loan-loss provisioning policy: term loans are collected through single, yearly instalments, and loans might be rescheduled if the default is not caused by moral hazard problems and the borrower intends to repay (see section 4.7). For each year that a loan is overdue, only 10 percent of the portfolio at risk is written off. Though ontime repayment rates for term loans had been quite low, less than 0.3 percent had been written off completely over much of the period prior to the financial crisis of 1997.

Table 5
On-time repayment rate of case-study institutions (%)

3. Issues in Developing a Term Finance Portfolio

This section discusses basic issues and principles that financial institutions intending to engage in term finance in rural areas must address. Based on the lessons of the case studies, it provides guidance for practitioners as well as for the donors and governments supporting them.

3.1 Designing Products and Developing a Financing Technology

The suitability and relative advantages of different term finance instruments largely depend on the characteristics of the potential demand, the legal and institutional framework for contract enforcement and the capacity of the RFI in terms of risk management and access to long-term funding sources. There may also be legal provisions that restrict the use of leasing or equity finance to certain types of financial institutions.

The effective demand for term finance products should be assessed through thorough market research. This should include an analysis of types of investment opportunities in terms of their profitability, capital requirements, cash flow and the scope for expansion of related economic activities. The risk profile of potential clients should be drawn up according to their farming and business skills, track record as borrowers, diversity and stability of income sources and expenditures, potential collateral, etc. Box 4 provides a checklist of the key elements of a market survey intended to guide the introduction of term finance products.

Though the suitability of term finance instruments has to be assessed on a case-by-case basis, some of their strengths and weaknesses will be briefly highlighted:

Term loans are well known and easily understood by farmers and may be used to finance a range of purposes by adjusting loan sizes and disbursement and repayment schedules. There are seldom restrictions on the type of financial institutions that can provide term loans; in principle, even non-financial institutions such as processing companies or equipment suppliers can provide them. The main difficulty in using term loans is the need to fix the repayment schedule ex-ante, based on assumptions that might change over the repayment period. Once the loan has been disbursed, adjusting the repayment schedule is problematic, in response, for example, to a major adverse event undermining the repayment capacity of the borrower. A second constraint involves problems of asymmetric information, moral hazard and adverse selection, which require tangible collateral and an effective legal and institutional framework for secured lending (see sections 4.2 and chapter 7). Thus very long-term loans are only feasible in a stable environment and where suitable risk-management tools and collateral are available.

Financial lease has the advantage that it reduces or even eliminates the need for additional collateral and problems related to the creation, perfection and enforcement of security interests - the financier is the owner of the assets financed. It may thus be particularly suitable in countries where weak legal and institutional frameworks create severe constraints on the use of rural assets for securing term loans. However, several issues have to be taken into account in designing leasing products for informal clients in rural areas. First, the concept of financial leasing is often unfamiliar to farmers, RFIs and local institutions, and its introduction may thus require higher set-up costs for capacity-building of local stakeholders. Second, since the financed asset is the main security and source of lease payments, leasing requires more supervision, resulting in high transaction costs. Finally, legal and regulatory provisions may restrict the use of leasing to certain FIs, or the tax treatment may discriminate against leasing.

Equity finance by existing or new shareholders has the advantage that it avoids fixed repayment schedules and costs. The participation of the financier as shareholder in the enterprise reduces moral hazard problems related to asymmetric information, and the enterprise in turn benefits from management expertise. The main limitations of equity finance relate to high transaction costs for appraisal and monitoring. This limits its use for smaller investments. It may, however, be suitable for financing larger-scale investments in processing and marketing that then enhance the profitability of farm-level investments. In this context, equity finance could be used for capitalizing joint venture companies of farmers, financial institutions and agribusiness. Equity finance requires specific skills that may restrict its use to specialized equity and venture capital funds and development finance institutions.

3.2 Importance of a Gradual Approach

The introduction of financial innovations usually requires several steps before a product can be launched and marketed on a larger scale. Apart from the market survey, they include the development and pilot testing of prototypes, followed by strict monitoring and adjustment^[25].

Adhering to such a gradual, phased approach is especially important in the case of more complex products, such as term loans or leasing, which expose the financial institution to greater risk and may require considerable adjustment of operational procedures and investment in institutional and human capacity. Staff have to develop new skills, for example in the appraisal of agricultural investment projects, including the assessment of market trends and production-related risks over longer time horizons. Moreover, term finance providers have to deal with legal and institutional issues regarding collateral and complex tasks in managing asset/liability and portfolio risks. The MIS also has to be customized to allow monitoring of the term finance portfolio and managing of these risks.

Most case-study institutions started with the provision of seasonal loans to farmers before venturing into term finance. This helped them become familiar with local production and marketing conditions, the specific risks of different agricultural activities, the importance of nonfarm income sources, types and quality of collateral that can be offered by farmers, etc. Their presence in rural areas also allowed them to establish good relations with local authorities, community leaders and other local institutions that can facilitate the screening of borrowers and instil loan repayment discipline. Knowledge of clients reduces moral hazard risks and allows flexibility regarding loan conditions and collateral requirements.

Once a sound rural clientele base is established, offering longer terms becomes less risky. Term loans can be offered first to promising clients with a sound track record as borrowers and proven farming and business skills. When the financing technology is tested, term finance can then be offered to new clients. Such a gradual approach helps minimize losses and institutional learning costs during an initial period of trial and error.

3.3 Identifying Suitable Regions

Selection of suitable regions is an important first step in venturing into term finance. Following the gradual approach, it is generally advisable to begin developing an agricultural lending technology in regions with high agricultural potential and relatively low risk and transaction costs. Once the financing technology and operational efficiency are satisfactory, and a pool of profitable clients has been established, the financial institution can gradually expand into other regions.

Good agro-ecological conditions (soil and climate), access to markets or processing facilities, and availability of inputs and support services such as extension and business advice are preconditions for commercial agriculture and thus for an effective demand for term finance. Irrigation and drainage facilities have an important impact on production risk. The existence of contracts between farmers and agribusiness enterprises or traders reduces risks related to the marketing of produce and availability of inputs. It may also provide scope for tripartite arrangements among financial institutions, farmers and buyers of produce.

Good infrastructure for transport, communications and marketing reduces transaction costs for lenders and borrowers, increasing the profitability of agriculture and reducing the cost of financial service provision. Population density is another important factor. Peri-urban areas are characterized by high population density and a higher share of non-farm income. The latter facilitates diversification of the loan portfolio. Moreover, clients with a broader range of income sources are less exposed to seasonal and agricultural risks and may be able to make more frequent loan payments.

Most case-study institutions started their term finance operations in high-potential regions, often in proximity to urban areas. However, one important caveat applies: underserved markets with relatively low risks and costs attract competition. This is in principle a healthy situation, contributing to a broader range of financial services and improved quality. However, it might lead to additional risk for lenders if clients begin borrowing from different sources and overindebtedness develops (see Box 5). Such a situation may occur if collateral is not available or cannot be registered and enforced properly, or if lenders are reluctant to share information about their borrowers, as happened in Bolivia in the late 1990s. Also, in regions with relatively low risk and high profitability, investors have increased access to finance from informal sources such as traders, processors and suppliers of agricultural inputs and equipment. These entities are often in a better position to enforce their claims.

An alternative strategy might be to gradually diversify lending into more remote areas. Here, a low degree of competition from other financial institutions facilitates assessment of the client’s debt situation and increases the scope for non-registered rural assets as collateral. Moreover, investors have a stronger incentive to maintain a good relationship and a sound reputation with the lender and are thus less likely to default. Such an approach might be especially viable if processing companies are located in these remote areas. Bulky, perishable crops such as palm oil, tea and sugar cane require immediate processing after harvesting. Frequently, optimal agro-ecological conditions for growing these crops are found in less populated areas at a greater distance from major urban centres.

3.4 Catalytic Role of Ancillary Investments and Support Services

Though starting with seasonal finance is generally the recommended approach for RFIs, two case studies demonstrate that, in some situations, complementary term investments are needed to address critical production and marketing risks, before short- and medium-term loans can be provided on a sustainable basis.

However, both institutions already had a long-standing presence in their rural areas, which facilitated the selection of viable clients and suitable regions. Moreover, they had accumulated considerable technical and economic knowledge in their activities. Few RFIs have the necessary skills, capacity and capital to manage and finance larger and more complex term investments and replicate the approaches developed by these two case studies. Coordinated approaches with diverse stakeholders will be needed in areas where ancillary investments are preconditions for the sustainable provision of short-, medium- and long-term finance to investors. FIs may engage in partnerships with agroprocessors, NGOs, local governments and donor-supported programmes. Equity finance and joint ventures might be possi- ble instruments for funding larger-scale investment linkages between primary producers and processing companies (see chapter 6).

Term finance providers need to ensure the availability of quality inputs and non-financial support services^[26] as important determinants for the risk and profitability of term investments. Some case-study RFIs have established partnerships with non-financial institutions such as NGOs or equipment suppliers. Cooperation with such institutions is most effective if the latter share the credit risk. This provides an incentive to ensure quality training and after-sales services, as well as to participate actively in the monitoring and supervision of borrowers.

Other RFIs provide non-financial support services - business development, strengthening of producer organizations or extension - either directly (CIDRE) or through specialized subsidiary companies (BASIX). The advantages of this approach are lower transaction costs and control of the quality of the services provided. However, there are related moral hazard risks if the lender chooses the equipment or provides support services, because the borrower could use ‘faulty advice’ from the lender as an excuse for loan default. Provision of financial and non-financial support from the same institution should thus be regarded as a second-best option.

3.5 Adopting a Relationship Banking Approach

An important lesson from microfinance is that small and informal businesses value a stable banking relationship with an RFI that can service the various financing needs of the household and the farm business(es). Reliable access to financial services helps farmers selfinsure against and cope with risks, finance life-cycle events such as marriages or funerals, and invest in the expansion of existing activities or diversification into new ones. It provides an incentive to honour their repayment obligations. Moreover, repeat transactions allow investors to establish a track record with the lender. It strengthens the ties between RFI and farmers and may contribute to enhancing mutual trust within a long-term relationship. Clients may establish social capital with the lender and become eligible for term loans.

Such a relationship helps the lender obtain information on the character, cash flow and skills of a client. This allows better screening of potential applicants for term loans and a more realistic assessment of the risk. As a result, a lender might be able to rely more on cash flow and less on collateral, which may to a degree overcome problems related to the limited availability of loan collateral. Longer terms at lower interest rates might be offered, which provides an additional incentive to maintain a good relationship with the lender.

A relationship banking approach also increases the viability of term finance in rural areas. Term loans or leasing may be introduced to complement other financial services and may be made available to more advanced and entrepreneurial clients to finance productive investments or even consumption goods if sufficient repayment capacity exists. The possibility of obtaining a term loan or a lease may provide an incentive to existing clients to repay short-term loans on time or, vice versa, convenient, fast access to seasonal finance and emergency loans may provide strong repayment incentives to borrowers of term loans.

Relationship banking works best in areas with low competition, for the reasons mentioned earlier. However, even in situations of increasing competition, it may be an important mechanism for FIs to retain their more profitable clients. Different incentive mechanisms (discussed in more detail in chapter 4) can be used to allow good clients and repeat borrowers faster access to loans, with more flexible terms, lower interest rates and lower collateral requirements.

3.6 Offering a Range of Financial Products

Offering a variety of financial services, including deposit facilities, short-term production or multipurpose loans and different term finance products, is a precondition for a relationship banking approach. However, it conveys a number of additional benefits to investors and providers of term finance.

Easy and reliable access to deposit facilities and short-term loans for production or emergency purposes helps farmers manage their farm household cash flow better and make frequent small loan payments. Access to emergency loans, credit lines or overdraft facilities may also have an indirect effect on the ability of rural households to self-finance investments in productive assets: some of the funds that would normally be kept idle or liquid in order to cope with emergency situations or for unforeseen expenditures can be used to finance risky start-ups or to complement term loans.

Attractive savings facilities help farmers accumulate equity to self-finance investments in new activities or to adopt new technologies on a pilot scale, before venturing into larger investments funded through debt financing. This allows them to gain management experience and establish a track record, which in turn facilitates access to larger loans with longer maturities for expansion. The accumulated funds can also be used for equity contributions or down payments, which reduces the risk in a term loan or lease.

Short-term loans sometimes finance term investments directly, especially those that can be expanded gradually or require staggered disbursements over several periods. For example, the planting of tree crops might be financed by the rolling over of short-term loans if the farm household has sufficient income from other sources^[27]. Using short-term loans for investment purposes might be indicated in unstable environments with high, fluctuating interest rates or for financing diversification into new and risky activities. Moreover, larger-term investments often increase working-capital requirements and thus the demand for short-term loans. Shortage of working capital may have a negative impact on the proper management and maintenance of investments and thus on the investors’ repayment capacity for term loans.

Access to short-term emergency credit as well as withdrawable savings can greatly facilitate consumption smoothing, and thereby increase the risk bearing capacity of farm households (Zeller, 2001). This, in turn, may enable poorer farmers to adopt new technology and undertake more medium-term investments more easily.

3.7 Strengths and Weaknesses of Types of Term Finance Providers

Financial versus non-financial institutions

Non-financial institutions such as suppliers and processors are important sources of seasonal finance in rural areas (buyer and supplier credit). The provision of credit is often interlinked with the marketing of produce.

Equipment suppliers may be interested in using deferred payments or leasing to promote the sale of equipment to potential clients unable to pay in advance, without the additional transaction costs and delays involved in seeking bank finance. Their main strengths compared to FIs are their technical knowledge of the equipment and the capacity to train clients and provide after-sales services such as warranty, spare parts and repair facilities. Processors might be interested in financing farm-level investments such as irrigation systems or (re)planting of perennial crops to ensure reliable quality and quantity of raw material. Their strengths lie in their ability to provide additional non-financial support services, such as inputs and extension, and a secure marketing outlet.

However, there were few examples in which equipment suppliers or processing companies provided term loans or leases to farmers. Equipment suppliers are either not involved in financing transactions at all, or they only agree to short-term deferred payments. In the few cases in which suppliers accepted deferred payments over longer periods, requirements for collateral and down payments tended to be at least as restrictive as those applied by financial institutions^[28]. Traders and agribusiness companies limit their financing activities mainly to inkind provision of seasonal inputs. Direct financing of term investments is rare and involves situations in which a single-channel marketing outlet reduces the risk of loan default caused by outside selling to third parties (see chapter 6). Some agribusiness companies provide services that require capital-intensive investment in assets, such as land preparation or transport. These companies have better access to term finance, can reap economies of scale, and ensure appropriate handling and maintenance of the equipment.

This points to some important weaknesses of suppliers and processors in providing term finance: their limited skills in appraising the creditworthiness and repayment capacity of farmers; the high cost of setting up and managing a loan administration and monitoring system; and their limited access to long-term funding sources.

Processing companies tend to have a narrow perception of farmers as suppliers of a specific raw material, not as complex household/business entities. Farmers are often encouraged to produce as much of the cash crop as possible and are not allowed to use inputs supplied on credit for any other purpose. This may result in overspecialization, which might not be problematic as long as product prices are high. It does, however, increase the vulnerability of farmers to price shocks or to losses from pests and diseases that attack the main crop. The likelihood of default increases if farmers do not have alternative farm or non-farm activities to meet subsistence and immediate cash needs, or cannot draw on savings or consumption loans. Moreover, in-kind provision of inputs does not substitute for the need to properly assess the complex interactions between farm and household cash flow: inputs are fungible and can be used for different crops or sold.

Larger equipment suppliers are often located in provincial capitals, which raises the cost of supervising clients. Smaller, village-based equipment dealers, who have better knowledge of their clients and increased possibilities for supervision, face limited access to long-term funding sources. This is often exacerbated by a legal framework that does not allow the use of inventory or outstanding term loan/lease portfolios to secure refinancing from banks.

In view of the complexities involved, the direct provision of term finance through non-financial institutions should generally be regarded as a second-best option. A possible exception may apply to perishable, bulky products that require immediate post-harvest handling and processing. Tripartite arrangements (e.g. among agribusiness companies, financial institutions and investors) are more promising, since they allow each party to concentrate on its own strengths. Financial institutions have economies of scale in administering loan accounts and can make use of existing software and MIS. They should also be involved in the screening and selection of borrowers, the design of loan products and loan appraisal. A further advantage of financial institutions is their ability to offer additional financial services, such as savings, emergency and consumption loans, which are particularly useful to poorer households (Zeller et al., 1997). Non-FIs can provide tailor-made training, a timely supply of quality inputs and extension services, post-harvest handling and marketing of outputs. Contracts need to be designed in a way that shares risks, costs and benefits and provides incentives to maintain the relationship over long time horizons.

Strengths and weaknesses of types of FIs

The case studies demonstrate that term finance can be provided by different types of financial institutions, including financial NGOs, mutualist FIs, agricultural development banks and NBFIs. The role and potential of specific types of financial institutions varies according to local conditions. This discussion will focus on the impact of location, size and legal status on the ability of FIs to provide term loans or leasing to farmers and rural microentrepreneurs.

Size and location are key issues. FIs based in rural areas face lower transaction costs in obtaining information about clients and local production and marketing conditions and, accordingly, in loan appraisal and borrower supervision as well. They can build on their existing knowledge and social networks and introduce term finance to expand the existing range of products. However, smaller RFIs are more vulnerable to local systemic risks, such as drought or pests. Diversification into different client categories or regions may help manage such risks, but smaller RFIs have limited possibilities for developing the skills, knowledge and financing technology that such diversification requires. Large institutions can diversify both their asset portfolio and their liabilities, thus combining the advantages of specialization and diversification.

To a certain extent, smaller FIs may compensate for their disadvantage in size by building networks and second-tier structures, which allows horizontal exchange of liquidity to cope with temporary shortage or excess. Through an apex body, they might also be able to access commercial funds, such as credit lines with commercial banks. Networks can also facilitate capacity-building and sharing of information and innovations.

A second issue relates to the legal status of a financial intermediary. Unregulated FIs may have greater flexibility in adjusting financial products and technologies to the specific features of their target market. They do not have to adhere to strict banking regulations, e.g. regarding the use of collateral and loss provisioning. This may allow them more flexibility in dealing with late payments if these are clearly the result of an adverse external event, beyond the responsibility of the borrower. However, this potential advantage also constitutes a major threat to the financial health of the RFI. This may be the case particularly for borrower-dominated FIs or financial NGOs with no clear ownership structure and weak internal control.

Legal status also determines which financial services can be offered and which funding sources can be mobilized. Due to the reasons mentioned in 3.5, FIs that are able to offer a range of complementary financial services are better able to establish a long-term partnership with clients. Regulated FIs have easier access to a broader range of funding sources (see next section).

In general terms, RFIs such as mutualist financial institutions, financial NGOs and other rural MFIs enjoy the advantages of proximity to clients and outreach in rural areas, but face the challenge of managing portfolio and asset/liability risks. Commercial banks are in the opposite position: they have good possibilities for diversifying asset portfolio and liabilities, but low outreach in rural areas, often combined with a cultural distance from the rural clientele. Agricultural development banks have the potential advantage of combining outreach in rural areas with size, but are often plagued by weak management and governance structures and by political influence on lending decisions. Still, BAAC and Land Bank have shown the sustainable outreach that reformed agricultural development banks can potentially reach if governance issues are tackled effectively.

3.8 Funding a Term Asset Portfolio

Importance of asset/liability management

As was pointed out in part A, financial institutions with a term finance portfolio must develop effective strategies for minimizing asset/liability mismatches and the associated liquidity, interest-rate and foreign-exchange risks. This topic is discussed in more detail in Agricultural Finance Revisited (AFR) No. 4 (Giehler, 1999). In view of the crucial importance of ALM for financial institutions engaging in term finance, some issues and options for funding a term finance portfolio from the perspective of financial institutions will be discussed. Policy implications for governments and donors will be outlined in part C.

Suitability of different funding sources

The suitability of different funding sources for refinancing a term finance portfolio depends on the characteristics of the portfolio regarding maturities, share of term assets in the total asset portfolio and the use of fixed or variable interest rates. Open positions (i.e. mismatches between asset types and funding sources) can relate to three areas: interest rates, amounts and duration of funds received and provided. FIs engaged in medium- and long-term finance should try to minimize open positions by accessing funding sources that closely match the terms and conditions of their asset portfolio. The generic features and suitability of different funding sources will be briefly discussed.

Equity such as retained earnings, paid-in shares or grants has the advantage of not having fixed costs or maturities (see chapter 6). Thus using equity to fund a term asset portfolio avoids interest-rate and liquidity risks^[29]. RFIs with a strong equity base are well equipped to engage in term finance.

Equity can be obtained from concessionary (donors, governments, development banks) or commercial sources (existing or new share- holders, investment funds, etc.). Many of the case-study institutions have received concessionary equity or grants from donors or governments, especially during the start-up phase. Member-owned institutions such as CECAM and MCRB collect shares from their owners and borrowers in different ways. To become members and thus be entitled to take out loans or leases, a minimal number of shares must be bought, which are only repaid upon termination of membership. Moreover, the size of the loan or lease a member can access is linked to the number of shares. This provides an incentive to buy more shares, enlarging the capital base of the RFI. Finally, equity is increased by deducting a certain percentage from each loan or lease.

One caveat applies to the use of equity: it may have serious implications for the ownership and governance structure of the RFI (Giehler, 1999). Both member- and government-owned institutions are under continuous pressure to expand lending and improve the terms for borrowers, often at the expense of lower prudential lending requirements.

Subordinate loans^[30] have fixed repayment periods, but rank below other commercial borrowing (senior debt) in the case of bankruptcy. The principal is usually repaid in one single instalment at the end of the maturity period (balloon repayment). These loans are normally unsecured or can be secured through a secondary claim on the company’s assets. Thus they require a higher risk prime and have higher costs than normal bank loans.

Subordinate loans are provided by commercial banks, venture capital funds, private investors with specific investment interests and singlepurpose mezzanine funds. They may also be available from national and international development finance institutions. The providers of subordinate loans do not participate in the management of the borrowing company.

The advantages of subordinate loans are longer terms, flexibility in designing the repayment schedule and the absence of influence in management decisions. The main disadvantage lies in the higher costs as compared with secured loans.

Bonds normally carry fixed-interest rates and can be issued with longer maturities. This reduces interest-rate and liquidity risks. However, not all financial institutions are allowed to issue debt instruments. Central banks and supervisory authorities often apply strict rules as to the type of financial institution allowed to issue bonds. Moreover, in order to attract funds from capital markets, lenders need to fulfil high standards of adherence to sound banking practices and good portfolio quality. Amounts, maturities and cost of funds depend on the rating in the capital market. The large fixed costs of issuing bonds make smaller amounts uneconomical and limit the use of this instrument to the largest and best-performing institutions.

Another capital-market instrument used prominently in developed countries for financing long-term loans is asset-backed securities. Retail financial institutions with a term loan portfolio backed by real estate mortgages can issue bonds on the secondary mortgage market. Mortgage-based lending does, however, require an active market for real estate and an appropriate legal and institutional framework supporting the creation, perfection and enforcement of security interests, which will be discussed in chapter 7.

Borrowing from national and international sources. Term assets can be funded through loans from other domestic banks on the interbanking market or through certificates of deposit. If terms and maturity structures can be matched, liquidity and interest-rate risks can be minimized through commercial borrowing. However, three caveats apply in practice:

• medium-term loans from commercial sources are relatively costly;

• often only shorter maturities are available; and

• the availability of funds is volatile.

These issues become more important with the increasing maturity of a term asset portfolio. Longer term loans at fixed interest rates may have to be refinanced several times, which exposes the lender to significant interest-rate risk. Commercial loans are highly risk and interest-rate sensitive: if temporary external events affect the portfolio quality of a lender, macroeconomic stability, or the profitability of important economic sectors, commercial borrowing will only be available at higher cost and with shorter maturities. Due to this volatility, it is difficult to refinance a stable medium- or long-term finance portfolio primarily through commercial borrowing.

International borrowing in foreign currency may be available at lower cost and with longer maturities, but may expose the RFI to currency risks, especially if most assets are in domestic currency. Borrowing from concessionary sources is frequently available with long repayment terms, including grace periods, and often at below-market cost. A major caveat involves indirect costs for reporting requirements and, in some cases, limited autonomy in the use of funds (onlending conditions, target borrowers, etc.).

Deposits are an important and cheap funding source for those FIs allowed to mobilize them. However, using deposits for funding a term loan portfolio implies high liquidity and interest-rate risks and requires considerable asset/liability management skill and a good MIS. The risks depend mainly on the term and size structure of the deposit base and its sensitivity to interest-rate fluctuations, as well as on the size of the financial institution and its access to refinance facilities.

Size of the RFI. Small RFIs with limited possibilities for coping with systemic risk are exposed to high liquidity risk. In the case of major adverse events, many depositors may want to withdraw their funds, while many borrowers may not be able to repay. In order to use deposits to fund a term loan portfolio, these institutions must have access to refinance facilities from the owners or from a second-tier institution.

Structure of deposits. The bulk of the deposits of RFIs often consists of a large number of small sight-deposit accounts of unknown duration. On the other hand, a significant share of the total deposits might come from a limited number of depositors, who might be interest-rate sensitive. Such a deposit structure increases the exposure of an RFI to liquidity and interest-rate risks.

Still, there might the possibility for those financial institutions that have established a suitable financing technology to use deposits to fund a limited portfolio of medium-term loans or leases. In rural areas with low levels of competition for savings, interest-rate sensitivity may be low and small rural deposits can provide a low-cost, stable base for funding. Some possibilities for using deposits for funding a medium-term portfolio include:

• using core deposits in combination with standing credit lines or liquidity pools within networks of FIs (see box); and

• designing term deposits and savings-cum-loan products.

There is little doubt that many developing-country banks could do more to develop savings products that are attractive, remunerative and designed to help clients participate more actively in the money economy. This is especially true of the development of term savings or savings-cum-loan products, i.e. adapting housing finance products for use in agricultural term finance. Several financial institutions in Africa, such as FECECAM, CECAM and the Equity Building Society, have recently introduced such products. The borrower would have to save a certain amount each week or month until a target amount is reached. He or she can then apply for a term loan at preferential interest rates. Further research would be required to explore the scope of such instruments. Deposit insurance would be an important tool to support savings mobilization strategies by enhancing public confidence and safeguarding deposits. It would also reduce the danger of a bank run.

Main implications for funding a term asset portfolio

The discussion of the pros and cons of different funding sources indicates that FIs should aim to diversify their liability structure to facilitate the matching of terms and costs of funds and assets, but also to reduce dependency on single funding sources. Liability-structure management is important to guarantee the solvency, liquidity and profitability of a financial institution by ensuring sufficient equity, as well as a mix of debt instruments.

Equity and subordinate loans are the best suited to funding a term finance portfolio because they minimize ALM risks. This is especially important for FIs with limited experience in term finance and for smaller FIs with little possibility of diversifying their liability structure. Long-term borrowing reduces liquidity risk for long-term assets and - if provided at fixed costs - interest-rate risk. However, in the case of international borrowing, currency risks have to be assessed carefully.

The ability of FIs to use deposits, bonds or central-bank rediscount facilities depends first on the banking legislation of the country. Core deposits and commercial borrowing might be important complementary funding sources. However, their use for funding term assets requires considerable ALM skill. They are most appropriate for larger, experienced institutions, which have a solid asset portfolio, a good rating in the financial system and a strong equity base. This applies even more to capital-market instruments such as bonds. Term deposits are interest-rate sensitive and may be used for financing medium-term loans at variable interest rates.