How to Stress Test Your Ag Portfolio
According to recent data, lenders are seeing elevated agricultural loan demand largely as a result of tighter profit margins among producers. The report, from the Federal Reserve Bank of Kansas City, stated that demand could remain high since futures markets for fall crops show prices are likely to remain low because of the potential for another record harvest. A separate set of recent data suggests that agriculture lenders are seeing increases in non-performing farm loans and decreases in farmland values.
Like other types of lending, banks must remain cautious to avoid too heavy of an agricultural concentration or too much lending within a certain ag segment. Without diversification, risks will be expounded.
According to the Comptroller’s Handbook on Agricultural Lending, the repayment of agriculture loans often depends on successful planting and harvesting of crops, or raising and feeding of livestock, and ultimately marketing the harvested item(s). The challenge is that market conditions in this type of lending tend to be volatile. And many of the risks associated with agriculture lending are out of borrowers’ control, according to the OCC:
- Domestic and global supply and demand changes
- Land values
- Government regulations
- Subsidy programs
- Changes in consumers’ preferences
As a result, borrowers are encouraged, in the OCC document, to implement risk management practices that reduce their exposure to these risks, including diversification strategies, operations integration, hedging, contracting strategies and/or purchasing insurance.
Similarly, ag lenders should also implement prudent risk management practices, including effective policies, processes, personnel, and controls, to minimize the impact of market volatility. One area that can help banks prepare for agriculture market volatility is stress testing, which can be performed for the entire agriculture portfolio and on individual segments.
Understand and limit risk in the portfolio.
An article written by Kraig Ritter, partner at BKD, LLP, highlighted the key stress testing elements for agriculture lending. Ritter referenced a 2011 Supervision and Regulation Letter, Supervisory Expectations for Risk Management of Agricultural Credit Risk, by the Board of Governors of the Federal Reserve System, citing four factors institutions should evaluate for proper management and control of their agriculture portfolio:
- Agriculture commodity prices
- Production costs
- Farmland values
- Global market issues
Ritter also provided several best practices for stress testing ag portfolios, including:
- Categorizing borrowers by risk rating and identifying “a certain percentage of coverage for each risk rating category to ensure the testing is representative of the portfolio.”
- Summarizing the coverage that stress tests provide over the segment, including the potential range of exposure like best and worst cases. He also suggested incorporating the data into the “institution’s capital plan to identify potential capital needs in advance.”
- Performing the analysis when the “majority of the lines are being renewed and update the data toward the end of the production cycle as more information is determinable, or sooner, if a significant event (change in commodity prices or weather conditions) would change the original analysis.”
- Using the data to support qualitative factors related to ag loans.
While stress testing isn’t currently required for banks under $10 billion in assets, it is often seen by regulators as a proactive best practice. Banks performing stress testing gain additional insight into their portfolio and are able to better identify potential risks, like too high of a concentration in a certain portfolio or portfolio segment. In a volatile industry like agriculture, stress testing on the elements referenced above and others, using mild, adverse and severe scenarios, among others, allows banks to understand the impact that changes could have. Banks can then aim to adjust lending standards, capital levels, concentration percentages and others based on the results.
Sageworks Credit Analysis for Agricultural Lending, powered by Abrigo, is an enhanced version of Sageworks Credit Analysis. The solution allows banks and credit unions to analyze ag, commercial and complex loans on one platform and helps lenders standardize and document lending to agricultural borrowers. .