Lending & Credit Risk Ag Lending Loan Pricing Risk Ratings

The Current State of Ag Lending: Challenges for Borrowers, Lenders, and How to Overcome Them

Kylee Wooten

January 29, 2020

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Key Takeaways

The FDIC issued an advisory to FIs encouraging safe and sound lending practices in today's ag lending environment.
Ag producers are predominately concerned about liquidity and income; lenders are most concerned about credit quality, competition, and weaker loan demand.
Technology has been a key resource for both ag borrowers and ag lenders seeking efficiency, growth, and profitability.

On January 28, the Federal Deposit Insurance Corp. (FDIC) issued an advisory to financial institutions encouraging exceptionally safe and sound lending practices in agricultural lending. Despite strong economic conditions early in the 2010s, the agricultural industry has faced significant headwinds in recent years.

“This advisory reminds financial institutions engaged in agricultural lending to maintain sound underwriting standards, strong credit and administration practices, effective risk management strategies, and appropriate allowances for losses and capital levels through the credit cycle,” the FDIC statement said. “When agricultural borrowers experience financial difficulties, the FDIC encourages financial institutions to work constructively with borrowers to strengthen the credit and mitigate loss.”

Uncertain economic conditions, such as low commodity prices, trade concerns, and adverse weather conditions, can pose a serious threat to both ag producers and ag lenders. Both borrowers and lenders must be vigilant and proactive to remain profitable and effective.

The current state of ag borrowing

Ag borrowers and lenders are currently face a variety of challenges, but there are a few areas that are of particular concern, according to the fall 2019 ABA and Farm Mac Agricultural Lender Survey. Ag producers are predominately focused on liquidity and income, while lenders are most concerned about credit quality, competition, and weaker loan demand.

On average, lenders reported that just over 57% of their agricultural borrowers were profitable last year, and a majority of respondents expect that number to continue to fall in the next 12 months. The stress on profitability led to a significant number of farm exits (47.7%) and higher levels of Chapter 12 bankruptcy filings (24.7%), the chapter of the U.S. bankruptcy code specifically designed to protect farmers and fishers.

The grim farm profitability landscape has led producers to alter their operating behavior. Some producers are finding alternative sources of income to offset their profitability woes. The passing of the 2018 Farm Bill, for example, legalized the regulated production of hemp, and it is becoming a hot topic amongst producers and lenders. Nearly half (49.9%) of ag lenders reported borrower interest in hemp financing. Producers are also looking toward ag technology to improve efficiency and lower their cost of production. Nearly a third of lenders (32.0%) reported an increase in technology investments in their areas, and a third (33.4%) of respondents noted that they expect the investment in ag technology to continue to increase in the coming year.

How ag lenders can overcome challenging ag environment

There are undoubtedly a number of headwinds ag borrowers and ag lenders are pushing through in today’s economic environment. To overcome these challenges, first and foremost, financial institutions must be vigilant in their lending and risk practices.

The top concern lenders noted in the survey, echoed by the warning issued by the FDIC, is credit quality. Financial institutions’ top priority when banking ag borrowers should be to work constructively with the borrower to strengthen the credit and mitigate loss. In spite of credit quality concerns, stiff competition, and weaker loan demand, lenders are optimistic about approvals. Survey respondents reported an average ag loan approval rate of 75.1% in the 12 months leading up to the survey and expect an approval rate of 90% for renewal requests in the following 12 months.

In a compressed lending environment, it can be tempting to loosen credit standards to attract new loans. However, like ag borrowers, ag lenders need to look to alternative sources to spawn new growth, improve efficiency, and lower the overall cost of production. Ag lending is inherently risky due to the number of environmental and economic factors that carry significant weight, and it’s essential to consider the strategies your ag financial institution can employ to mitigate the risks associated with ag lending.

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Leverage technology to mitigate risk and gain efficiency

Sluggish commodity prices and climbing expenses for farmers puts added pressure on small ag banks (banks with total assets under $500 million and at least 15% of the loan portfolio in ag production or ag real estate loans), which have significantly increased loan volume since 2012. This uptick in loan volume may be good for bankers, but it poses a significant risk to small ag financial institutions, as these institutions are more likely to use manual underwriting processes and use a more subjective analysis to credit risk.

Like ag borrowers, ag lenders can employ technology to improve efficiency, while also bolstering credit quality to mitigate risk. Today’s technology affords ag lenders the ability to efficiently calculate the creditworthiness of ag borrowers and understand the global credit risk associated with the borrower. Prudent underwriting practices are a fundamental element of ensuring credit quality. Many institutions still rely on manual data entry and underwriting processes, which can lead to errors and inaccuracies that negatively affect credit quality. However, by leveraging technology built specifically for ag lenders, your financial institution can maximize consistency and efficiency through streamlined data entry, time savings with tools like the Electric Tax Return Reader, and centralized access to all ag borrower data in a single platform for analyzing all loan types.

In addition to efficient and robust underwriting practices, Rob Newberry, Senior VP of Credit Risk Services at Abrigo, encourages ag to carefully price loans to account for the risk it is taking on. “If you are getting paid for the risk you are taking on, you will not only survive but thrive in the current market conditions,” Newberry said in a recent whitepaper, The Ag Lender’s Survival Guide.

As the FDIC noted, institutions must have strong risk identification and control practices in place. To do so, your financial institution should structure loans so that they qualify for guarantees and share some of the risk involved with the loan. Additionally, your institution needs to objectively price loans based on the risk you are taking on. By leveraging technology, your institution can take the guesswork out of assigning risk ratings and loan pricing to make more informed, sound lending decisions.

There is no escaping the headwinds that are associated with ag lending in the current environment, but there are ways to hurdle the challenges ahead. Producers are scrappy and trying new strategies for growth and efficiency, and ag lenders should do the same. The FDIC statement is an excellent reminder for ag lenders to be proactive in planning for the future and actively stress test the portfolio to maintain safe and sound loans.

From eliminating manual data entry to standardizing the risk rating process, there are numerous initiatives your credit union can leverage to ensure sufficient controls in place to underwrite loans more efficiently while maintaining – even improving – credit quality to make smarter loans.