Agricultural Lending Concentrations: Lending Well in Challenging Times
by Matthew Nankivel, Risk Team Manager, Federal Reserve Bank of Minneapolis
The ongoing impact of low commodity prices coupled with high input costs on agricultural producers and their lenders is a concern shared by bankers and supervisors and remains a key supervisory focus for the Federal Reserve System. In 2017, five Reserve Banks1 with responsibility for the banks with the largest exposure to agricultural lending conducted a coordinated supervisory review of their agricultural banks and identified opportunities for industry guidance to help bankers strengthen their risk management programs. This article builds on guidance in Supervision and Regulation (SR) letter 11-14, “Supervisory Expectations for Risk Management of Agricultural Credit Risk,” by providing an overview of several key risk management practices that are important for agricultural banks to consider.
The Importance of Federal Reserve SR Letter 11-14
SR letter 11-14 applies in all economic environments, but it is especially important in a period of economic stress because it reminds banks that “the identification of a troubled borrower does not [prohibit] a banker from working with the borrower.” Many banks engaged in agricultural lending are located in communities where farming is the primary economic driver, and simply pushing every borrower with challenges out of the bank does not benefit the long-term interests of the bank or the community it serves. SR letter 11-14 provides a road map for lenders to work prudently with troubled borrowers in a way that serves the long-term interests of all stakeholders.
The Reserve Banks’ review provided examiners with helpful insights into a bank’s management of carryover debt. For the purposes of this article, carryover debt is the remaining debt on an operating line after all inventory on hand is sold. This definition does not include cash shortfalls caused by prepaid expenses or short-term extensions secured by grain in the bin. Carryover debt discussed in this article is an operating loss that must be appropriately secured and termed out in a way that meets the borrower’s needs and is also in the bank’s best interest.
The Reserve Banks’ review also revealed that more than four-fifths of agricultural banks included in the review had some level of carryover debt on their books, a figure that is expected to grow during the 2018 operating cycle. The loan structure of the carryover debt varied, but it was often amortized over three to seven years, with the bank taking additional collateral. However, it was not uncommon for banks to term out the debt as a refinance of the farmland, which allows for a much longer amortization period. This is a prudent approach as long as the borrower’s equity in the land is earned (that is, not tied to market gain) and the structure of the new note is within the bank’s lending guidelines. Many banks were able to obtain Farm Service Agency guarantees for these borrowers, which helped to mitigate the overall risk of loss, and a few banks required borrowers to sell noninventory assets to cover the operating shortfall.
Do Reserve Bank examiners view all borrowers with carryover debt caused by an operating loss as adversely classified borrowers? The answer is no. If the carryover portion of the borrower’s debt is adequately collateralized and appropriately amortized, and if the borrower’s financial condition is sound and within the bank’s policy parameters, the borrower’s debt often does not warrant adverse classification. Lenders with good risk management practices segregate carryover debt, secure it with additional collateral if possible, and amortize it over a reasonable term that is consistent with the borrower’s repayment capacity and collateral pledged. However, if the borrower does not have the financial capacity to prudently amortize the carryover debt, in addition to normal credit needs, or the borrower lacks sufficient equity to adequately collateralize the loan, then the borrower may warrant adverse classification for at least the portion of the debt that is carried over. Bank management should also assess whether the debt restructuring efforts warrant a Troubled Debt Restructure designation.
The guidance in SR letter 11-14 addresses risk management practices for carryover debt and for mitigating the risk of loss from troubled borrowers, thereby minimizing classified loans. Following the approaches discussed in SR letter 11-14, the Reserve Banks’ review noted that although most banks had a few borrowers with carryover debt, nearly half of the banks did not adequately address carryover debt in their loan policies, and many banks did not have formal guidelines. A loan policy for carryover debt should address acceptable types of collateral, loan-to-value limits, and acceptable amortization requirements, including whether a bank is willing to refinance farmland to provide longer amortization periods for carryover debt. Additionally, the loan policy should address requirements for monitoring loans with carryover debt, including requirements for determining when the bank should consider a formal action plan. An action plan often covers borrower commitments to reduce costs, control family living expenses, bring in additional off-farm income, sell assets, and possibly incorporate a loan covenant to prioritize repayment of the carryover debt. Above all else, an action plan should be realistic and prudent for the circumstances and repayment ability of the borrower and should be actively monitored by the lender.
Managing an asset concentration is a fundamental aspect of strategic risk assessment and capital planning. Most banks that are highly concentrated in agricultural lending are making loans based on the needs of the local market. Often, they do not have easy ways to diversify the concentration risk without engaging in out-of-area lending, which carries its own risks. Whether a bank chooses this type of diversification is a decision for the bank’s board and senior management, but capital planning should aid the bank in managing its concentration risk and lending strategy. Regardless of whether agricultural banks diversify, a significant portion of the portfolio remains directly or indirectly tied to the health of the local and regional agricultural economy, and, therefore, sufficient capital coverage for this risk is necessary.
A number of banks reviewed were not formally considering the agricultural credit risk concentration in their capital planning processes. Discussions related to capital planning often considered long-term projections and contingency plans. These aspects are necessary to the long-term planning process, but in the case of agricultural credit risk, it is also important to discuss capital planning in real time. Most important, before declaring dividends, the bank should consider whether its allowance for loan and lease losses and capital levels will adequately insulate the bank against expected and unexpected losses. Bank management should not only consider expected and potential losses on adversely classified credits but also account for overall growth in operating lines from carryover debt and credit concentrations.
For agricultural banks, liquidity risks are interwoven with the loan portfolio’s credit quality. Because agricultural producers often are both loan and deposit customers, when commodities peak, bank deposits rise and operating loan demand falls, leaving the bank with excess deposits. In the current environment of low commodity prices and high input costs, the opposite is true, and many banks seek funding outside of their local deposit base. In addition to seasonal fluctuations in funding needs, this economic cyclicality has caused an increased reliance on wholesale funding. Because banks in this position often find it difficult to maintain a healthy level of unencumbered liquid assets, the best option is to employ strong risk management practices against the increased level of liquidity risk. At a bank with tight liquidity, management should also consider the need to restrict discretionary lending to limit loan growth.
The Reserve Banks found that banks were often not adequately linking agricultural concentrations to the liquidity planning process and that assumptions were sometimes inconsistent. For example, bank cash flow projections under adverse business conditions typically incorporated assumptions for increased carryover debt but held deposits constant. This approach fails to recognize the full impact of borrowers’ financial stress on the bank. When preparing cash flow forecasts and stressed cash flow projections for contingency funding plans, a bank should consider the unique risks posed by agricultural lending concentrations as agricultural borrowers typically hold deposits at the bank. Therefore, a bank has to consider the effect that these customer relationships have on both the bank’s assets and liabilities and the potential liquidity constraints.
A bank’s liquidity planning process should include thorough accounting for off-balance-sheet commitments, consideration of the impact of reduced deposits on the bank’s cash flow, assessment of the funding needs for loan growth derived from seasonal swings and carryover debt, and consideration of how rising interest rates will affect weaker borrowers. The bank should also establish monitoring frameworks for managing liquidity risk, including limits on wholesale funding tied to loan demand, so that when a bank exceeds those limits, it triggers appropriate action from management.
Robust risk management is always foundational to managing concentration risk. During times of increased risk, strong risk management practices are even more critical to maintaining a healthy bank that has the necessary resources to serve its customers and community. The guidance provided in SR letter 11-14 outlines the elements of a risk management framework an agricultural bank should have in place to successfully underwrite agricultural borrowers, including borrowers with carryover debt.Back to top