This chapter summarizes the findings and presents a series of recommendations for financial institutions wishing to embark on agricultural term finance. Its last section suggests concrete measures by which donors and governments can support financial institutions and enhance the economic, institutional and policy environment for expanding the frontier of term finance.
Though term finance is generally more risky than short-term finance given its longer time horizon, risks vary considerably according to investment purpose, type of borrower and the legal, institutional and market environment. These factors are highly situation-specific: the feasibility of term finance and the suitability of different instruments have to be assessed on a case-by-case basis. For example, mediumterm leases or loans to experienced farmers for the purchase of farm machinery or equipment are not necessarily more risky than short-term loans if the equipment is used to secure the transaction and generates a steady cash flow. However, long-term loans with grace periods, for the establishment of tree-crop plantations, for example, present high risks. Long-term finance depends to an even greater extent than shortterm on a stable environment, the availability of specific risk-management instruments and access to suitable refinance facilities.
Moreover, some term investments such as irrigation or storage facilities reduce the exposure of farming operations to certain production and market risks. They may lower the risk profile of a client, increase the profitability of the business, and thus trigger further loan demand, e.g. for incremental working capital. The general risks related to longer-term finance have to be traded off against the risk-reduction features of term investments and their impact on future demand for additional loans.
Individual farmers vary greatly in their risk profiles, depending on their skill and experience, level and diversity of income sources, and their ability to make down payments and provide collateral. Financing the expansion of existing activities is clearly less risky than financing startups or diversification into new activities. Most of the case-study institutions target farmers that have experience or training in the planned activity. Identified marketing outlets and diversity of income sources are other selection criteria. Availability of support services, quality inputs, irrigation, and processing facilities shapes the risk and profitability of farming. Most term finance providers operate primarily in areas with good infrastructure, including irrigation, and in proximity to markets or processing companies.
Costs are also situation-specific: transaction costs vary according to population density, the quality of road and communications infrastructure and the legal and institutional framework for secured lending and contract enforcement. In comparison with short-term and micro loans, term loans offer a considerable advantage in transaction costs if total costs are related to the amount disbursed. This may compensate for higher absolute costs for loan appraisal and supervision, cost of funds and loss provisions.
The level of loss provisions depends not only on the determinants of risk already discussed, but on the experience and skill of the financier as well. Experienced lenders - with a good knowledge of clients, agricultural activities and investment opportunities - can better assess risks, select viable loan applications and obtain and analyse information at lower transaction costs. This is then reflected in lower loss provisions and operational costs, enabling the lender to make larger loans with longer maturities at lower cost to the client.
A good financing technology allows RFIs to single out viable investment projects and manage idiosyncratic client risks at a reasonable cost. Term finance requires specific skills to appraise the stability of the borrower’s cash flow over time, the risks and profitability of investments and the quality of collateral. Providers of seasonal loans with an established pool of clients, familiar with local production and marketing conditions, are better equipped to engage in term finance. Still, considerable training and possibly recruitment of specialized staff with agricultural backgrounds may be needed.
Financing technologies and product design should be adapted to the characteristics of clients and the capacity of the lender. For example, less experienced lenders can first provide multipurpose term loans as a form of extended short-term loan. These loans reduce problems related to the fungibility of money and are suitable for financing smaller investments, new clients and risky activities such as diversification into new crops. More experienced lenders may offer specific-investment loans to finance larger investments that considerably alter farm household cash flow.
The scheduling of repayments involves a compromise between the lender’s preference for short maturities and frequent instalments and the borrower’s preference for longer maturities and instalments adapted to the agricultural calendar. Long maturities and grace periods enhance affordability of investments for borrowers but increase moral hazard and liquidity risks for lenders. Short maturities and frequent instalments add to transaction costs and may lead to illiquidity for the borrower. Successful term finance providers demonstrate a high degree of flexibility in adjusting repayment schedules to the cash flow of individual borrowers and investments, taking into account seasonality of income and expenditures.
Term loans require monitoring and supervision. Frequent contact with borrowers enables lenders to anticipate possible default and to differentiate the underlying cause: moral hazard or external factors beyond the responsibility of the borrower. Though a strict policy is needed in the case of wilful default in order to maintain credit discipline, the high incidence of systemic risk in agriculture requires some flexibility towards default caused by temporary external events, at least in the case of repeat borrowers. To enable such flexibility, term finance providers need a strong equity base and access to refinance facilities. Costs can be reduced by joint liability mechanisms or by partnerships with equipment suppliers, processors or NGOs, introducing an element of risk sharing.
Term finance products can be offered at the lowest risk if RFIs adopt a relationship banking approach based on the desire of both client and RFI to maintain a long-term partnership. Investors can build a track record and RFIs can obtain first-hand information, permitting flexibility in collateral requirements and in dealing with default.
Offering various products strengthens the ties between investors and RFIs: the possibility of obtaining term finance can be an incentive to maintain a good track record with the lender. In turn, continuing access to short-term loans for working capital or consumer purchases can be linked to timely repayment of term loans. Moreover, as term investments tend to reduce risk and enhance the profitability of a client’s business, term finance may set the basis for future loan demand.
From a dynamic perspective, adding term finance to an existing range of products can benefit financial institutions. An RFI offering a ‘onestop shop’ for the diverse financial requirements of business and household activities will attract new clients. However, selection criteria and collateral requirements need to be more stringent for first-time borrowers.
Term loans are the most widely used instrument because they can finance a wide range of investments and allow a considerable degree of flexibility in designing disbursement and repayment modalities. Moreover, the concept of lending is better known and more readily understood by financiers and farmers than leasing or equity finance. The main limitations are a repayment schedule based on assumptions formulated at the time of loan appraisal, the difficulty in adapting to changes, and the need for tangible collateral, especially in the case of longer terms and larger amounts.
Financial lease offers the advantage of reducing or even eliminating the need for additional collateral and the 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 frame- works 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, as just mentioned, the concept of financial leasing is often unfamiliar to farmers, RFIs and local institutions, and its introduction may therefore require higher set-up costs for capacity-building of local stakeholders. Second, as 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 it.
Equity finance by existing or new shareholders avoids fixed repayment schedules and costs. The participation of the financier as shareholder in the enterprise reduces moral hazard problems related to asymmetric information, while the enterprise benefits from management expertise. The main limitation is 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 in turn enhance the profitability of farm-level investments. In this context, equity finance could be used to capitalize joint venture companies of farmers, financial institutions and agribusiness. However, it requires specific skills, which may restrict its use to specialized equity and venture capital funds and development finance institutions.
Larger RFIs have comparative advantages in offering term finance products. They can manage systemic risks through portfolio diversification, and the number of term loans they can provide is enough to warrant developing a specific financing technology to manage idiosyncratic risks. Moreover, they have better access to a broader range of funding sources. For smaller RFIs, the establishment of networks, access to refinance facilities (or additional owner capital in case of a major external shock), and the availability of risk-management instruments are especially important. Their main advantages are their proximity to clients, good knowledge of local conditions and (in the case of non-regulated financial institutions) greater flexibility in introducing financial innovations.
There is little documentation of equipment suppliers, agribusinesses and traders providing term finance to farmers, despite their importance as sources of seasonal finance. A possible exception may involve perishable, bulky products that require immediate post-harvest handling and processing. The limitations of suppliers and processors as providers of term finance include:
limited skills in appraising the creditworthiness and repayment capacity of clients;
the high cost of setting up and managing a loan administration and monitoring system;
limited access to long-term funding sources; and
lack of interest in providing term finance to farmers.
However, non-FIs can play an important role in tripartite arrangements with financial institutions and farmers, e.g. through sharing risk or providing complementary services. Interlinked transactions may be used to reduce transaction costs for loan collection and collateral requirements. They work best in environments with limited competition if deductions for loan repayment are calculated transparently. The example of RBP in the Philippines shows that equity participation by farmers in downstream enterprises can enhance trust and reduce the incentive for default caused by outside selling of produce.
The reluctance of many RFIs to engage in term finance is partly attributable to the high set-up costs of developing new products and procedures, training and recruiting specialized staff and accessing long-term funding sources. Moreover, the likelihood of default is greater during the initial launching of new products, when many of the risks are still unknown and the RFI does not yet possess the skills to assess and manage them adequately. Many RFIs, especially smaller ones, are not willing or able to fully assume these risks and costs. Moreover, lack of access to suitable long-term funds may expose lenders to considerable asset/liability risk.
Well-designed, targeted donor support is especially important during the initial phase. Seed funding and technical assistance may encourage the development of term finance products by sharing the risk and costs. Most of the case-study institutions received such support. A case could be made for a public good element in introducing viable term finance instruments that enhance the financial infrastructure in rural areas. If the viability of term finance can be proven, other RFIs might replicate successful approaches. Moreover, many rural and agricultural term investments have important spillover effects in terms of poverty reduction and enhanced competitiveness. Government and donor support means that all institutional learning costs do not have to be shouldered by the RFI or transferred to clients through higher interest rates.
A good lending technology, careful product design and a relationship banking approach can overcome some but not all constraints on the provision of term finance. The case studies show that scaling up of term finance portfolios requires the tackling of structural constraints as well. The key issues are an enabling legal and institutional framework for secured lending and instruments to manage and reduce systemic risk:
Addressing collateral constraints. Collateral substitutes such as joint liability mechanisms, co-guarantors, or the pledging of unregistered assets such as land, equipment or household goods can be used in securing smaller term loans. This is most effective if clients have a long-standing relationship with the lender and there are few other sources of finance on comparable terms. However, larger term loans with longer maturities require additional collateral. Moreover, if competition among lenders increases, the use of nontraditional collateral might become problematic in that clients might pledge the same asset to different lenders. The scaling up of small, local term loan portfolios requires an enabling environment for secured transactions. The terms and conditions of loans (amounts, maturities, grace periods and interest rates) depend on the availability and quality of collateral. Legal, regulatory and institutional constraints on the creation, perfection and enforcement of security interests restrict the use of rural assets as collateral in many developing countries, and these constraints need to be addressed urgently.
Managing systemic risk. Effective demand for term finance depends on the investor’s ability to manage and cope with systemic risk. Irrigation and storage infrastructure, and the accessibility and quality of agrochemicals, planting material or breeding stock enhance the resilience of farmers. Still, major external shocks such as drought or price drops are difficult for investors or financial institutions to manage at the local level and may require access to specific risk-management tools such as agricultural insurance. Innovative instruments such as area- and index-based crop insurance show some promise in managing the risks related to climatic events and they avoid the flaws of conventional crop-insurance programmes. However, practical experience in the use of these instruments in developing countries is still limited.
Based on the experiences of the case-study institutions, recommendations can be offered for building up a term finance portfolio at reasonable risk and cost.
Adopt a long-term business development strategy: introduce term finance as part of a long-term strategy in recognition of the potential longer-term benefits. Investments in market research, product design, financing technology, staff training, MIS adaptation, etc. are crucial, but only amortize over a longer time horizon.
Take a gradual approach to introducing and expanding term finance in order to spread out set-up costs and minimize initial losses while skills and procedures are being developed. Start with short-term loans in order to become familiar with local production and marketing conditions and establish a viable client base. Grant term loans to existing borrowers first, and to new clients only when the financ- ing technology has been proven. Offer multipurpose term loans, based on existing farm household cash flow, before introducing specific-investment term loans to be repaid partly or mainly out of the incremental cash flow generated by the investment.
Offer a broad range of financial products, including deposit facilities, short-term loans and savings-cum-loan products, as part of a long-term bank/client relationship. This allows clients to graduate into term loans, accumulating capital for financing start-up activities or making down payments. Ensure that clients have access to sufficient working capital for the proper operation and maintenance of the investment. Emergency loans can stabilize the farm household cash flow and help cope with adverse events.
Focus on financing the expansion of existing activities and the scaling up of proven technologies for which support services are available. Restrict financing of new activities to repeat borrowers or to those with stable, diversified cash flow and suitable collateral. Consider offering multipurpose term loans and/or term savings products for diversification investments.
Avoid standardized loan products based on cash-flow models of specific term investments when providing term loans to small and informal borrowers. Appraise repayment capacity on the basis of a complete assessment of all sources of income and expenditure related to the business and household and of their stability over time. Base projections of farm household cash flow on conservative assumptions, especially in the case of first-time borrowers. These can be relaxed for repeat borrowers. Adjust repayment schedules as closely as possible to the projected income of the farm household and the cash flow generated by the investment. Avoid long grace periods and stipulate the payment of interest.
Price term loans according to client risk: clients may be classified in different risk categories according to their experience, past repayment performance, down-payment capacity and availability of collateral. Repeat clients may be offered lower interest rates.
Take a flexible stance towards collateral: maximize the use of collateral substitutes for smaller term loans and emerging commercial farmers through repayment incentives. These could include the possibility of access to future loans on improved terms and conditions, peer pressure and pledging of assets with high personal or economic value for the borrower. Accept experience, skills, track record and sound cash flow as partial substitutes for collateral. In the case of larger loans with longer maturities, combine conventional loan collateral with collateral substitutes.
Consider financial leasing for the medium-term financing of equipment if term loans are not feasible due to legal and regulatory constraints and if the regulatory and tax environment does not have a strong antileasing bias.
Seek partnerships with non-financial institutions: establish partnerships with equipment suppliers to ensure client training, provision of after-sales services, client supervision and bulk purchases of equipment. Ensure that suppliers share part of the credit risk, e.g. through deferred payments, based on the repayment performance of clients. Build partnerships with farmer organizations, local authorities or NGOs for client screening and supervising, creation of peer pressure, extension services and business advice. Liaise with local governments to ensure the infrastructure complementary to investments, such as roads and irrigation or marketing facilities. Negotiate arrangements with processing companies to ensure stable marketing channels for outputs, availability of inputs and technical assistance. These types of arrangements could also include in-kind loan collection.
Governments and donors can foster the supply of term finance through two main avenues:
supporting financial institutions through technical and financial assistance to the design and introduction of new finance products and technologies; and
enacting coherent policies and complementary measures to create an enabling economic, institutional and policy environment and to strengthen effective demand.
Supporting product innovations
Financial institutions may be supported in the introduction of term finance products through technical assistance in the following areas:
internationally disseminating best practices in the design of term finance products and financing technologies, e.g. through publication of case studies, training materials, international workshops and staff exchanges;
developing and pilot testing prototypes of term loans or financial leases;
training loan officers and staff of credit committees in the proper appraisal of loan or lease applications; and in accounting, financial management and internal control to ensure professional management and efficient operations of rural financial institutions during their start-up and consolidation phases;
building capacity of staff regarding the legal, regulatory and tax issues in those RFIs interested in financial leasing;
upgrading MIS in order to improve individual loan/lease tracking and overall loan portfolio management; and
establishing partnerships with non-financial institutions such as equipment suppliers, agribusiness, NGOs and local governments.
Mobilizing long-term funding sources
Financial assistance in the form of long-term subordinate loans or equity allows FIs introducing term finance products to concentrate on managing the asset side of the business. A concessionary element in the cost of funds may be justified in order to compensate the RFI for the high initial risks and transaction costs. Such support has to be gradual, performance-based and of limited duration. It may be most effective if complemented by technical assistance along the lines outlined above.
Once a term finance technology has been developed successfully, RFIs can be helped to diversify their liability structure by accessing commercial funding sources. Possible areas for support include:
strengthening the asset/liability management skills of RRFIs;
establishing common liquidity pools, for instance by constituting associations or federations of similar institutions;
assisting in the design of term savings and savings-cum-loan products;
providing guarantee mechanisms for accessing credit lines from commercial banks or accessing capital markets through the issue of debentures and bonds; and
investing equity so as to strengthen the capital base of RRFIs, facilitating access to commercial borrowing and other debt instruments.
The provision of long-term refinance facilities to established financial institutions may still be important in the following situations:
capital markets do not generate appropriate long-term funding sources for refinancing the long-term loans required for term investments;
smaller financial institutions with a viable term finance technology cannot access suitable funding sources in the market to expand their term finance operations, e.g. due to regulatory constraints.
In these cases, funds should be priced at market rates so as not to discourage development of commercial funding sources. Moreover, financial institutions should carry the full credit risk. Such support should be closely monitored and available only to well-managed financial institutions with a strong equity base and sound portfolio quality.
Support to financial institutions to develop term finance products is most effective as part of a broader rural development strategy. Areas of particular importance for government action and donor support are the following:
Ensuring sound, coherent macroeconomic and sectoral policies
Low, stable interest and inflation rates and realistic foreign exchange rates are preconditions for providing term finance and for a profitable agricultural sector. Measures aimed at enhancing the supply of rural finance through financial institution-building will be ineffective if urban bias or high inflation rates limit effective demand. Donors can support policy formulation and reform through policy dialogue and through technical assistance efforts such as stakeholder workshops or sectoral studies.
Improving the legal and institutional framework for secured lending
Legal and institutional reforms that improve the creation, perfection and enforcement of security interests are likely to have important long-term benefits for the expansion of term finance, despite the time horizon for implementation. Key measures would include legal and institutional reforms to broaden the range of assets that can be used as collateral, including movable assets such as equipment, livestock, crops, inventory and receivables. Registration systems for filing security interests for real estate and movable assets should be reformed to enhance speed and convenience and to reduce the cost of accessing information. This may involve computerization of registries and the introduction of notice filing systems. Finally, legal provisions and administrative procedures should be reformed to ease contract enforcement and foreclosure on collateral.
Where the basic institutional and cultural preconditions exist for rural land markets, a mortgage law could stimulate the development of capital- market instruments, such as the securitization of mortgages on land and other types of asset-backed securities. This would open up additional sources of long-term funding for refinancing loans for land development or for the establishment of perennial crops.
Promoting financial leasing
The promotion of financial leasing as an alternative term finance instrument may require legal reforms to ensure fast and non-bureaucratic repossession of leased assets and to modify legal and tax provisions that discriminate against leasing. Restrictions preventing certain financial intermediaries or equipment suppliers from leasing should be avoided, as should requirements that commercial banks engaging in leasing must open leasing subsidiaries. Legal reforms should be complemented by capacity-building of local institutions (e.g. courts, police).
Improving rural infrastructure
Investments in rural infrastructure for transport, marketing and communications enhance the profitability of agriculture, reduce transaction costs and stimulate effective demand for term finance. Irrigation and drainage systems reduce exposure of farmers to climatic risk and enhance the scope for diversification and intensification.
These measures also trigger private investment and enhance the viability of term finance. They might be particularly important as kickstarters in marginal rural areas, setting the scene for expansion of the finance frontier. Financial institutions alone will seldom be willing or able to finance these investments. Innovative approaches to combining different funding sources need to be explored, including farmers and local communities, commercial investors and public funds.
Supporting farm diversification and innovation
The introduction of new technologies may require initial support in terms of training and seed funding, since these activities may be too risky for RFIs. The same might apply to new enterprises requiring capital investment. Suitable technology for small commercial farmers is often not available and may need to be tested on a pilot scale. Once the technical and economic feasibility has been proven, RFIs can take over and finance the scaling up of new activities or technologies. Governments and donors may then support the establishment of private- sector supply chains for inputs and investment goods in order to ensure the availability of reliable, low-cost technology and related support services.
Strengthening downstream activities
Development finance institutions could provide equity finance, long-term loans and subordinate loans to capitalize small- and medium-sized processing companies, with important spillover effects on farm-level investment. Equity finance, in combination with long-term debt instruments, can also be used to capitalize joint venture companies of agribusiness, farmers or farm workers and financial institutions.
Improving access to information
Market-information systems, market research on diversification options and information on new technologies or farm data systems help farmers and RFIs identify profitable investment opportunities and assess risks and market trends. RFIs would also benefit from improved borrower information systems such as credit bureaus. Donors could strengthen the capacity of the private sector, government departments and civil-society organizations to conduct market research and price analysis of agricultural commodities. This would lead to more informed decision-making by investors and RFIs. Extension services and farm business advice enhance the capacity of farmers to adopt good agricultural practices and improve their business and financial management skills.
Making risk-management tools available
Governments and donors might provide seed funding and technical assistance for pilot testing the introduction of area- and index-based crop and livestock insurance (contract design, selection of appropriate indicators, data management, etc.).
Cyclical price fluctuations are a major constraint on term finance and cannot be managed through short-term, price-risk management instruments such as put options, forward contracts or hedging. Research into novel ways of designing approaches and instruments to manage cyclical price fluctuations would be crucial to expanding term finance for many agricultural commodities.
