Managing Credit Risk in Rural Financial Institutions in Latin America

Executive summary: Rural areas lack banking services due, in large part, to perceptions of high risks and high costs of delivering financial services. In Latin America, it is estimated that less than five percent of rural households have access to formal credit. Even though agriculture is declining in economic importance and non-farm activities are becoming more important over time, agriculture remains the main livelihood activity for many. Agriculture, however, is inherently more risky than other sectors due to its vulnerability to climatic shocks, commodity price volatility, and trade restrictions. In the current context of ongoing globalization and the quest to reduce rural poverty, agriculture will have to maintain and improve its competitiveness. Ready access to agricultural finance is one of the main ways of improving agricultural competitiveness. Therefore, it follows that lending technologies and, in particular, rural credit management techniques must improve.

This report examines a sample of forty-two financial institutions in Latin America that have agricultural portfolios, and identifies their principal perceived risks, how they assess and manage credit risk, and how effective they are in the process as measured by key financial performance indicators (such as asset quality, portfolio growth, and profit margins). We find that these institutions are relying on four techniques to manage risks:

  1. Expert-based, information-intensive credit technologies wherein repayment incentives for clients and performance incentives for staff play important roles, and information acts as a virtual substitute for real guarantees are being used to reduce risk.
  2. A number of diversification strategies (geographic, sectoral, commodity) are being used to cope with risk.
  3. Portfolio exposure limits (requirements that agricultural credit be less than 40 percent of total lending) are being used to reduce risk.
  4. Excessive provisioning is being used to absorb and internalize risks.

The largest challenge for expanding credit in rural areas is that few institutions are transferring credit risk to third parties. In developed countries, massive expansions of credit have been due in large part to the introduction and wide diffusion of risk transfer techniques (such as insurance, securitization, derivatives, swaps, etc) and the wider acceptance of different types of collateral (inventories, accounts receivables, warehouse receipts, etc.). In the sample surveyed, the most common risk transfer instrument available and used (albeit only by 25 percent of the respondents) is publicly financed guarantee funds, which have historically been plagued with problems such as high costs, limited additionality, and moral hazard. In order to introduce some of the other risk transfer instruments more commonly found in developed financial markets, investments will be needed to reform and strengthen the insurance industry, capital markets, credit bureaus, commercial codes, secured transaction frameworks, and information disclosure rules.

The implications of using these credit risk management techniques are many. First, credit evaluation technologies are very expensive and tend to increase operating costs and, as a result, the interest rates charged by financial institutions. Second, some minimal economies of scale and scope are necessary. Statistical evidence supports the contention that the larger rural finance institutions in the sample can more easily diversify risks, offer a wider range of products, obtain better efficiency ratios and charge lower lending interest rates. Clearly, agricultural lending cannot be the primary type of lending unless more robust risk transfer techniques become more commonplace. Third, the credit technology used in agricultural microfinance is an adaptation of urban microfinance technology and has limits for more commercially oriented and specialized agricultural borrowers. New technologies will have to be developed or adopted.

At present, a common set of credit evaluation principles seem to be widely applied:

  • Employ well-prepared staff that has some background in agronomy.
  • Use staff performance incentives to promote a sense of responsibility and to reward results.
  • Gather and use copious amounts of information on character, managerial ability, reputation for repayment, and financial viability to identify “good borrowers.”
  • Rely principally on cash flow and sensitivity analysis to determine repayment capacity.
  • Give preference to households with diversified streams of income and that are somewhat insulated from weather risks (larger homesteads, fragmented plots in different microclimates, and those that use of irrigation).
  • Use repayment incentives to avoid strategic defaults.
  • Monitor clients closely.

In conclusion, most institutions surveyed saw market opportunities in rural areas, and the most successful institutions were expanding their agricultural portfolios and generating profits. However, much can still be done to improve credit risk management by improving the feasibility of transferring risk to third parties.

The report makes several recommendations for donors and governments. The preferred or best option is to provide support to rural institutions that meet minimum scale requirements that would permit easy diversification of credit risk, and help them to expand and innovate. In countries where these types of rural financial institutions are absent, the second best option would be to assist those institutions that have a clear strategic commitment to the rural sector as well as competent management to upgrade their technologies, diversify, and introduce risk transfer instruments. The third best option would be to promote mergers and acquisitions among smaller institutions so they can reach a larger scale. The fourth best option would be to promote value chain financing, since many of the credit risks are attenuated by participation in a chain.

(Extract taken from original document.)

  • Resource type
  • Author Sergio Navajas, Alvaro Tarazona Soria, Carolina Trivelli, Mark Wenner
  • Organisation
  • Year of Publication2007
  • Region
  • LanguageEnglish
  • Number of pages36 pp.
  • EditionSustainable Development Department Best Practice Series

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