Discussion Points For Chapter

• Past policies for agricultural credit, which were based on the creation and maintenance of State agricultural development banks, control and subsidization of interest rates on loans, and use of directed credit allocations by crop on a massive scale, have failed in all regions of the world. The fiscal cost was high, benefits usually were regressive in their incidence over farm households, and the development of more viable rural financial institutions was discouraged.

• With the failure of this approach, the supply of credit to agriculture has been reduced significantly in real terms in most developing countries. Small- and medium-scale farmers have suffered most from this credit reduction.

• New approaches to agricultural finance are being developed that emphasize the creation of sustainable financial institutions.

• Returns to investment in developing agriculture can be very high, but market imperfections of

176. Scheme for Agricultural Credit Development, 1999, p. 115

various kinds have prevented greater flows of financial capital into agricultural investments.

• One of the keys to sustainable agricultural finance is mobilization of greater amounts of savings in rural areas. The capacity and desire to save in financial form exists in rural areas in all countries, but financial institutions have not always developed the most appropriate instruments for attracting savings, nor have monetary policies always been supportive of this aim.

• Informal finance can be productive in agriculture but its scale is limited, often by restrictions in the regulatory framework which prevent, for example, the securitization of suppliers' credits.

• Agricultural credit markets are characterized by geographical dispersion, high risk, market segmentation, asymmetric information between lenders and borrowers, and the frequent presence of excess demand for credit at prevailing interest rates.

• Three major problems that are widespread in agricultural credit markets in developing countries are: (1) the screening problem - borrowers differ in the likelihood that they will default, and it is costly to determine the extent of that risk for each borrower, (2) the incentives problem -it is costly to ensure that borrowers take those actions which make repayment most likely, and (3) the enforcement problem - it is difficult to compel repayment. Sustainable rural financial approaches and institutions need to find ways to deal with all three of these problems.

• The past approach of allocating credit among crops and livestock products by governmental fiat usually led to unprofitable lending and encouraged investment in lines of production that were not necessarily in a country's comparative advantage.

• The approach of microfinance emphasizes reaching low-income clients and it attempts to achieve sustainability through the use of innovative lending techniques and, in many cases, through local savings mobilization. So far, it has had a greater impact in urban and periurban areas and, within rural areas, in supporting non-agricultural activities, but in some cases it also has expanded lending to smallholders. However, by the same token it is clear that microfinance alone, as valuable as it is, will not fulfill the need of agriculture for greater access to finance.

• Microfinance programs do not necessarily reach the very poorest households but empirical evidence shows that they do reach significant numbers of borrowers below the poverty line.

• One of the important contributions of microfinance is increasing income levels of rural women. They have generally proven to be more dependable borrowers, and an additional unit of spending power in a woman's hands tends to have greater benefits for household nutrition and education than an additional unit in the hands of men in the same household.

• Sustainability for a financial institution requires, eventually, eliminating dependence on donated or subsidized funds and achieving profitability at a commercial cost of capital. Usually, sustainability in these senses is reached in stages.

• Other key strategies for attaining institutional sustainability include setting interest rates at market levels, developing sound governance and capable management of financial institutions, and designing the institutions' financial services with a market orientation.

• At the policy level, supporting the efforts of rural financial institutions to achieve sustain-ability requires appropriate regulatory frameworks, for agricultural finance as well as microfinance, and a national economic policy framework that is favorable to agricultural development.

• The risks faced by microfinance institutions differ in some important respects from those faced by commercial banks. For example, they are less exposed to risks of insider lending and of concentration of the portfolio in a handful of large loans. On the other hand, they face significant risks in the areas of ownership and governance and management and risks arising from the nature of their portfolios and the fact that they are a relatively new kind of activity.

• Microfinance institutions depend to a considerable extent on developing social collateral since most of their clients cannot offer physical collateral as loan guarantees.

• The provision of agricultural finance can be expanded, through both banks and non-bank financial intermediaries, by policies and legislation that widen the forms of collateral that is legally allowed. Examples include pledging usufruct rights to a plot of land for a specified period (antichresis), crops in storage and in processing, other forms of movable collateral, and accounts receivable and loans extended. In many developing countries, this is an area that has not received sufficient emphasis.

• Strengthening the regime of contract enforcement also helps encourage more agricultural finance. This is often a major weak point in developing economies.

• Ceilings on interest rates in the formal financial sector usually are counterproductive. Non-interest costs of obtaining a loan often exceed the interest costs, and in any case lending in the informal sector comes at a very high interest cost. Capping interest rates has the effect of discouraging lending to the sectors with interest controls and inhibiting the possibilities for savings mobilization. It also fosters use of non-economic criteria for allocating financial resources and tends to direct part of those resources to low-productivity uses.

• Regulation of financial institutions can be divided into prudential and non-prudential types. The former involves the regulatory authority in guaranteeing the soundness of the regulated institutions and therefore protecting depositors. The latter involves many requirements for starting up financial institutions and accounting and audit procedures, and reporting and disclosure obligations. Both kinds are important tools for supervising the growth of the financial sector.

• Another classification characterizes regulations as preventive (avoiding crises) and protective (handling crises once they have occurred). The former class of regulations can be further divided into entry requirements and ongoing requirements.

• Among the entry requirements, a common error is to set minimum capital levels too low.

Especially in agriculture, lending institutions need a strong equity base. Ownership requirements are important for ensuring that the owners bring to the institution a clear vision of its aims and context, as well as financial strength.

• Agricultural loans generally should be assigned a higher risk classification. This increases the cost of lending to agriculture but is necessary to ensure the sustainability of the financial institutions that lend to the sector. Likewise, agricultural portfolios need to be backed with higher liquidity ratios.

• Traditional bank regulations governing the nature of collateral are not always applicable to agriculture, especially when social capital (group lending) is utilized. Equally, loan documentation and reporting requirements, repayment intervals, and criteria for past-due loans all may have to be different for agricultural lending and for microfinance. Branch restrictions developed for commercial banks also may not be applicable for rural and small-scale lending operations.

• While many financial regulations need to be different for microfinance and agricultural portfolios, it has been argued that small-scale deposit-taking at a local level need not be brought under the umbrella of prudential regulation, because supervision could not be effective and the result would be to prohibit access to deposit facilities for many poor families.

• Equally, it has been argued that the creation of a special regulatory window should wait until there are enough microfinance institutions that are suitable for licensing, because regulation itself has a significant cost, both for the authorities and for the regulated entities.

• Rotating credit funds have been in existence for centuries, if not millennia, and they have generally functioned well at a local level on a small scale. However, the expansion of this concept into credit co-operatives tends to create institutions that are dominated by borrowers and not by those who have invested capital in the institutions. Hence, their financial performance has tended to be weak.

• Credit co-operatives can be made into stronger institutions with appropriate reforms that focus on ownership and governance, interest rate policies, and the types of financial services offered.

• To satisfy the financial needs of many small-and medium-scale farmers, greater emphasis could be placed on encouraging rural banks, or agricultural banks, a few of which exist already. These banks do not lend exclusively to agriculture, because the risk would be too high, but they devote a significantly higher share of their portfolio to lending in the sector. To be viable, such banks need to be willing to compensate for agricultural risks with higher interest rates, adopt some of the lending techniques of microfinance institutions, decentralize their operations as much as possible to take advantage of local knowledge of production conditions and clients, use innovative forms of capital, and improve their information systems and staff training.

• Apex organizations, or second-storey institutions that support systems of agricultural banks or microfinance institutions, can play a valuable role in liquidity management, obtaining access to additional funds, and offering technical advice. However, they suffer from a number of weaknesses. Their presence can complicate the system's vision and cloud governance issues, and differential growth rates among the primary-level institutions can strain the system. Therefore, apex institutions and the associated systems need to be designed and monitored with care.

• Another option for guaranteeing the long-term viability of small-scale financial institutions is for them to affiliate with larger banks. Increasingly, banks are purchasing stakes in those institutions.

• The financial instrument of rediscount lines has been justly criticized for directing lending to inappropriate lines of production and low-productivity uses, but nevertheless international development institutions continue to support it in special cases. There are major gaps in funding for agricultural development, especially for long-term capital needs, and rediscount lines can play a useful role in filling those gaps on a transitional basis.

• International bond markets represent another potential source of financing for agricultural development, in cases of well-organized associations of producers for particular products, but the requirements for tapping those markets are demanding.

• For both financial systems and individual financial entities, governance issues are critical. They basically concern the establishment of relationships of accountability and transparency.

• The few successful government financial institutions that function in rural areas are invariably characterized by a great deal of operational autonomy.

• Some microfinance institutions direct most of their lending to women, since they often are better financial clients on average and tend to make better use of borrowed funds than male clients do. However, in most financial institutions there still is a pro-male bias, attributable in part to the ways in which lending institutions are accustomed to work and the legal nature of collateral requirements. Legal reforms, training and awareness building can help overcome the barriers to more lending to women.

• Innovative lending policies have permitted the authorization of unsecured loans. They include criteria for borrower eligibility, incentives for repayment and techniques of monitoring borrower behavior. These new policies represent responses to the three basic problems faced by lenders in rural credit markets, of screening potential borrowers, providing incentives for compliance with loans, and enforcing repayment obligations.

• The new lending policies include various forms of group guarantees for loans. Limited liability schemes, in which all borrowers in a group make deposits into a fund which will be returned if all loans are repaid, appear to be more workable than requiring all members to be totally liable for the loans of all other members. Any form of group lending requires social cohesiveness and sufficient information about the other members of the group.

• Just as new lending techniques have been developed by microfinance institutions, new savings mobilization techniques have emerged as well.

However, introduction of deposit instruments into a financial institution greatly expands its workload and responsibilities. It fundamentally changes a financial institution and is a more demanding step than sometimes is supposed.

• Prudential management of a microfinance institution requires attention to capital adequacy, the role of a board of directors, liquidity levels, management information systems and procedures for recognizing risk, internal auditing procedures, performance incentives for staff, and portfolio diversification, and it also requires efforts to control costs.

• It has been argued that deposit rates are generally too low in developing countries, that they often reflect oligopolistic market positions of banks, and therefore that regulatory authorities should raise them instead of endorsing the banks' positions on these rates. This would enhance a country's prospects for financial savings mobilization.

• Highly inflationary conditions present a special case in which deregulation of lending rates may have to be deferred until inflation is reduced, since agriculture cannot pay high nominal interest rates. Under inflation and high interest rates, total costs of production rise much more rapidly than output prices.

• Donor finance can play a useful role, especially when it is linked to technical advice, is used for transitional purposes (such as starting up institutions), and subsidizes access of target populations to finance. It also can fill the gaps that exist in regard to availability of long-term loans in agriculture and forestry. Donor contributions to the financial system should be accompanied by other support for reducing market imperfections through, for example, land titling and the development of transport infrastructure.

• Commodity exchanges can represent large sources of finance for production and marketing.

• Developing agricultural finance requires application of the lessons learned in microfinance and also the development of a regulatory framework unique to lending for agriculture. The normal bank regulatory requirements for capital adequacy, liquidity, loan classification and monitoring, reporting and branch establishment are not applicable to much of agricultural lending. For these reasons, commercial banks typically are not very interested in agricultural lending. In the past, the policy response was to create State agricultural development banks. A better policy may be to create a regulatory environment that can make agricultural lending more attractive to private financial institutions.

• To encourage more private agricultural banking, a policy decision also needs to be made in regard to who pays the higher risk of agricultural lending, borrowers (farmers) or taxpayers, or a combination of the two. If a decision is made in this area and a special regulatory regime is instituted for agricultural lending, it can be expected that the volume of agricultural finance may increase instead of continuing its downward trend in relation to needs.

• As valuable as lending to rural women is, it needs to be recognized that often women do not control the funds that are lent to them. To enable women to participate more fully in managing finances, and their economic destiny, reforms are also needed in basic areas such as property rights legislation and educational policies.

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