Default risk in agricultural lending, the effects of commodity price volatility and climate

Abstract

Purpose -Commodity price volatility and small variations in climate conditions may have an important impact on the creditworthiness of any agricultural project. The evolution of such risk factors is vital for the credit risk analysis of a rural bank. The purpose of this paper is to determine the importance of price volatility and climate factors within a default risk model. Design/methodology/approach -The authors estimate a generalized linear model (GLM) based on a structural default risk model. With the estimated factor loadings, the authors simulate the loss distribution of the portfolio and perform stress test to determine the impact of the relevant risk factors on economic capital. Findings -The results indicate that both the price volatility and climate factors are statistically significant; however, their economic significance is smaller compare to other factors that the authors control for: macroeconomic conditions for the agricultural sector and intermediate input prices.Research limitations/implications -The analysis of non-systemic risk factors such as price volatility and climate conditions requires statistical methods focussed on measuring causal effects at higher quantiles, not just at the conditional mean, this is, however, a current limitation of GLMs. Practical implications -The authors provide a design of a portfolio credit risk model, that is more suited to the special characteristics of a rural bank, than commercial credit risk models. Originality/value -The paper incorporates agricultural-specific risk factors in a default risk model and a portfolio credit risk model.

Determinants of Agriculture-Related Loan Default: Evidence From China

“…However, the effect of temperature seems to be very modest. This result is consistent with the work of Castro and Garcia (2014), in that warmth and rainfall contribute to agricultural production as long as they do not surpass certain thresholds. The Year dummies have an effect on default; however, in this paper, the main idea is for them to absorb macroeconomic factors that are not included in our control variables.…”

“…Weber and Musshoff's (2012) results suggest that, in the Tanzanian loan market, agricultural firms have lower delinquency rates than non-agricultural firms do. Castro and Garcia (2014) and Ouyang and Zhang (2019) find that commodity price volatility and climate factors have a modest impact on agricultural loans, while macroeconomic conditions for the agricultural sector and intermediate input prices have greater influence. Dinterman et al (2018) study how economic factors have impacted farm businesses in the United States.…”

Can agricultural credit scoring for microfinance institutions be implemented and improved by weather data?

“…Furthermore, de Nicola (2015) found that climatic factors explain variation in loan default. In addition, Castro and Garcia (2014) also found a significant effect of climatic factors on default of agricultural loans. In summary, even though farmers show a good repayment performance, the direct dependence of production on external weather factors leads to the perception that agriculture is riskier than other business.…”

“…In summary, weather patterns can be linked to agricultural loan default, and extreme weather events are likely to increase the rate of default. Castro and Garcia (2014) emphasized the need of banks to manage common risks to agriculture through quantitative risk management. Dercon (2004) showed that the economic impact of a rainfall shock is long-lasting.…”

The Basel accords, capital reserves, and agricultural lending

“…Various quantitative approaches can be used to evaluate the safety and soundness of lending institutions (Castro and Garcia, 2014). Lending institutions source capital from various entities and provide capital to borrowers.…”