Solid, But Falling Profits At Agricultural Banks

The U.S. financial crisis has trimmed the profitability of agricultural banks and other commercial banks. However, agricultural banks performed much better than their banking peers. The strongest performance emerged from smaller agricultural banks.

Based on Agricultural Finance Databook information, the financial performance of agricultural banks weakened in 2008.1 The Federal Reserve defines agricultural banks as commercial banks with agricultural loans accounting for more than 14 percent of their loan portfolio.2 According to the Federal Reserve, the average return on assets and equity at agricultural banks steadily declined in 2008. By September 2008, the return on equity at agricultural banks declined to 7.6 percent, and the rate of return to assets edged down to 0.8 percent (Chart 1).

Agricultural bank returns, however, were much stronger than returns at other commercial banks. By September 2008, returns for all commercial banks had plummeted more than 70 percent, with the return on equity dropping to 2.86 percent and return on assets falling to 0.28 percent.3 Agricultural banks also had much stronger performance than other similarly sized small commercial banks, those with less than $500 million in assets. The return on equity and assets at smaller banks was 2.4 and 0.3 percent, respectively, well below the returns at agricultural banks.

Several factors contributed to the dip in agricultural bank profits. First, interest rates on agricultural loans have declined, trimming gross revenue on loan activity. According to agricultural credit surveys from the Federal Reserve, interest rates on all types of agricultural loans have dropped significantly below 2006 levels.4 The average interest rate on operating loans dropped from more than 9.0 percent in 2006 to 7.0 percent in the fourth quarter of 2008. During the same time, the average rate on farm real estate loans fell from roughly 8.5 percent to 6.75 percent.

A rise in the cost of capital also squeezed bank profits. One measure of the cost of funds is the London Inter-Bank Offered Rate (LIBOR), the rate banks pay to borrow funds from other banks in the London money market and a benchmark for other short-term interest rates. In September, the financial crisis fueled a spike in LIBOR, which raised the cost of funds for banks. The spread between the interest rate paid to acquire funds (LIBOR) and the interest rate earned on agricultural loans narrowed, suggesting lower profit margins (Chart 2). In the fourth quarter, the spread widened as LIBOR fell sharply, suggesting some improvement in bank profitability.


However, loan delinquencies have edged up, trimming agricultural loan profitability. In 2008, delinquency rates on agricultural loans climbed steadily from 1.08 percent in the first quarter to 1.23 percent in the third quarter (Chart 3).5 At the same time, net charge-offs on agricultural loans rose from 0.12 to 0.19 percent. Delinquency rates and net charge-offs on agricultural loans rose faster in the largest 100 U.S. banks. In fact, at smaller commercial banks, delinquency rates on agricultural loans actually declined.

Delinquency rates and net charge-offs on agricultural loans remain well below other types of loans and help explain the relative strength of agricultural bank profitability. For example, the delinquency rate on all types of loans and leases was 3.65 percent in the third quarter of 2008, almost triple the rate on agricultural loans. Net charge-offs were 1.46 percent, more than seven times the size of net charge-offs on agricultural loans.

(Source: Kansas City Federal Reserve, Jason Henderson, Vice President and Omaha Branch Executive.)