As the financial crisis deepened, agricultural banks outperformed other commercial banks - but they still saw their profits decline. Despite questions regarding credit availability, commercial banks are extending credit to agricultural borrowers at lower interest rates. The soft erosion in agricultural loan quality, however, has led agricultural lenders to tighten credit standards and shift more financial risk to borrowers.
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.
Impact on agricultural lending
Despite their relatively strong performance, agricultural banks tightened lending standards to preserve capital and manage the risk arising from the economic downturn. Agricultural banks continue to originate agricultural loans at relatively low interest rates. However, banks are increasing collateral requirements and shrinking loan maturity as agricultural loan quality deteriorates.
Agricultural banks, in general, report ample funds available for operating loans.
For example, according to the agricultural credit survey of the Federal Reserve Bank of Kansas City, 70 percent of bankers reported the amount of funds available for farm operating loans in the fourth quarter of 2008 was unchanged from the year before, with an additional 14 percent having more funds available. And these banks expected to have roughly the same amount of funds available in the first quarter of 2009. Moreover, only 4 percent of the bankers reported refusing a loan due to a shortage of funds, the same percent as in 2007.
Nevertheless, agricultural bankers responding to the Kansas City Fed’s agricultural credit survey reported raising collateral requirements on operating loans.6 In the fourth quarter of 2008, the collateral requirements index rose almost 20 percent above year-ago levels (Chart 4).7
Other Federal Reserve data indicate that farm real estate accounted for roughly 17 percent of the collateral used for the nation’s farm operating loans in the fourth quarter of 2008, up modestly from previous years. The use of farm real estate as collateral was more prevalent in larger operating loans. Moreover, small and mid-sized banks tended to use farm real estate as collateral more often than larger banks.8
The increase in collateral requirements does not appear to have severely restricted loan activity in the agricultural sector. In fact, farm debt levels rose through 2008. By the third quarter of 2008, farm debt held at commercial banks was 8.2 percent above year-ago levels, with real estate debt up 10 percent and non-real estate debt up 6.3 percent. The volume of non-real estate loans rose sharply in the fourth quarter, with increases to both the crop and livestock sectors.
While banks still made loans, they adjusted loan terms in response to the increased risk associated with farm lending. The average risk rating on agricultural loans edged up in 2008, and bankers continued to report deteriorating loan quality as livestock profits were elusive and margins declined for the crop sector.9
And carry-over debt appears to be rising, as more agricultural bankers reported an increase in operating loan renewals and extensions in the fourth quarter. In response to higher risk, banks reduced the length of operating loans. For example, after steadily rising since 2001, loan maturity on agricultural loans dropped 20 percent, to 12 months, in the fourth quarter of 2008. Simply put, as agricultural risk increased, banks were more reluctant to extend loans for longer periods of time.
Risks to agricultural lending in 2009
The recession poses many risks to agricultural lending in 2009. In terms of supply, the further deepening of the financial crisis could limit funds for agricultural loans. At the same time, a weaker farm economy could erode the creditworthiness of agricultural borrowers when loan needs are most pressing.
A primary risk to agricultural lending is the availability of funds. Banks can raise funds from a variety of sources - equity and debt markets, deposits, and nontraditional sources such as Federal Home Loan Banks. A deeper financial crisis could threaten a bank’s ability to raise funds from nondepository sources.
For example, some large agricultural lenders have struggled to raise debt capital by issuing commercial paper. After peaking in November 2007, the volume of commercial paper issued by domestic financial institutions had dropped roughly 15 percent by the fourth quarter of 2008. Moreover, equity values of larger banking institutions have fallen, which also limits their ability to raise capital.
Bank deposits are a major source of loanable funds for agricultural banks. The risk is that lower interest rates on CDs and other savings vehicles could slow bank deposit growth, limiting funds available for agricultural loans. Through the third quarter of 2008, domestic deposits at agricultural banks remained above 2007 levels, according to the FDIC. Still, rising job losses from the recession pose a risk to deposit growth because people could lose their income stream and tap savings for household needs. In turn, fewer deposits could limit funds for agricultural loans.
Despite these risks, smaller agricultural banks have access to federal government and Federal Reserve funds. In response to higher risk, agricultural bankers indicate they are increasing their use of guarantees from the U.S. Department of Agriculture’s Farm Service Agency. Moreover, small agricultural banks have access to primary and secondary credit funds through the Federal Reserve’s discount window and have the ability to request funds for seasonal credit, especially during the planting and harvest seasons, when funding needs are more significant.10
Another pressing concern is the creditworthiness of agricultural borrowers. In 2009, profit margins for crop producers are expected to narrow, and profitability for livestock producers is expected to remain elusive (Henderson and Akers). While loan defaults remain low, delinquency rates, charge-offs, and risk ratings are rising, and continued deterioration in the agricultural economy could further erode the creditworthiness of agricultural borrowers. Further weakness in agricultural loan quality could lead to additional tightening of lending standards and an increase in loan denials for agriculture.
In sum, the financial crisis and resulting recession have dimmed economic prospects for the agricultural economy and trimmed profits at agricultural banks. Still, agricultural banks have performed much better than other commercial banks and appear to have funds available for agricultural loans. However, a steeper downturn in the agricultural economy could erode the creditworthiness of borrowers and further tighten credit standards on agricultural loans. With the combination of weaker profits at financial institutions and rising risk on agricultural loans, agricultural borrowers are being asked to accept more of the financial risk emerging from a volatile agricultural environment.
