Why Indian Banking industry must be allowed to participate in the emerging Indian Commodity derivatives industry.

Question : What does the Farmer want[1] ?
Answer : The Farmer requires Credit ,Water and Market[2]

CREDIT
MARKET
WATER
Whereas the lenders approach has always been from the credit risk point of view , if the lender has an over all view of the business risk process and adopts suitable hedging strategies using structured derivative products, the approach would not only benefit the Lender but also the Farmer, the governments and the society at large.
So incase of the Agricultural lender in order to minimize his npa, more in particular of the “SOCIAL OBLIGATIONS” of government which may suddenly decide to waive of recoverable, This research paper tries to have an holistic approach on this area and proposes to the agricultural lender a risk hedge matrix based mathematical model on which he can offset his risk .

How to improve access of farmers to agricultural lending?

As per the author, some of the characteristics of price risk management instruments that can enhance access to agricultural credit:

Have a market-based approach.
Assess agricultural portfolio by linking it with exposure and market price of proceeds on exposure.
Create a cushion to protect against price falls.
Short positions including using derivatives like futures and options (Options is currently not available but the talk is of this instrument being made available by the financial year end.)
Provide short term insurance coverage.By cross selling insurance products through strategic alliances with Insurance firms.
Encourage intermediaries for aggregating farmers and meeting contract size.


The author state that traditional crop insurance has suffered from high administrative costs, moral hazard and adverse selection. As a result there is a need for index-based weather insurance, which the author is confident, is just a question of time before which it becomes a reality.

What does the Weather index do?
It compares a measurable, objective, correlated risk to yield.
It has a rainfall index that is designed with historical weather data. If, rainfall levels drop below threshold, then insurance pays out.
It is designed like a put option; farmers select trigger level and scope of coverage.

Innovative ways for improving access to agricultural lending:
Liquid collaterals to improve creditworthiness of agricultural producers.
Warehouse receipts to access financial support.

The reality though is that a few small farmers know in advance what price they will receive for their produce when they sell it and as a result small farmers around the world watch pensively as the prices moves throughout the season. These farmers may not know the daily movements of the international prices but they do know that the price they are being offered by local traders is constantly changing. They also know that if the price drops when they are ready to sell their produce they will not be able to cover their costs of production, send their children to school/pay for household expenditures, or pay back their creditors.

Low market prices limit the income farmers receive from their products, but it is the unpredictability or volatility of these prices that makes it difficult for farmers to optimize production technology, time sales, use assets, and, in most cases, access credit.

Financial services providers are often not willing to lend to small farmers because of farmers’ lack of traditional collateral and the possibility of default on loans in the face of a fall in commodity prices.

Attempts have been made in the past - minimum price guarantees by state owned marketing boards, international commodity agreements, and state subsidized lending institutions - to help farmers deal with volatility and access credit, but these schemes have proven difficult to sustain, costly, and inefficient.

An alternative approach - market based price risk management instruments

The use of market based price risk management instruments, derivatives, can help farmers deal with the price volatility by effectively reducing the uncertainty caused by movements in international commodity prices that affect their business. In this way, the use of price risk management instruments - called hedging - can improve the quality of the lender’s portfolio and help eliminate one of the primary reasons that farmers do not repay loans: unrealized assumptions about levels of projected income and return because of sharply or suddenly falling international commodity prices at the time of selling. These instruments could substantially reduce the risk that many lenders see in lending for commodities.

Price risk management instruments and lending institutions

The small production volumes of most individual farmers make it necessary to involve an intermediary institution that can aggregate the demands of many individual farmers for a risk management instrument into the minimum size traded on international markets. The interest for banks and other financial institutions in playing this role would be to link loans to price risk management tools in order to protect their own risk profile and provide a valuable financial service to its credit facilities.

Financial institutions could combine hedging with lending in three main ways:

1. Hedging for themselves the exposure of their overall portfolio to seasonal falls in commodity prices.
This could allow financial institutions to restructure their portfolio, extend repayments, or even forgive part of the interest and/or principal repayments when a severe price shock occurs;

2. Hedging on behalf of their borrowers, thus attaching a hedge to each loan;

3. Requiring that borrowers provide evidence of price protection measures taken when they come to negotiate a loan (in this final case, farmers would have already accessed risk management instruments through their producer organisation or exporter).
This would allow banks to expand or restart their agricultural loan portfolios, while giving farmers better access to credit and/or opportunity to borrow at better terms.


Who can access these instruments?

Tools to insulate producers and businesses from the negative effects of short- term price volatility are very widely used in high-income countries, but the vast majority of agricultural producers in developing countries have been, in general, unable to access these markets to date.

Some traditional barriers to entry have prevented small holders from accessing these tools including:

Contract size
Lack of knowledge of such market-based price insurance instruments
Limited knowledge about how to utilize them
An unwillingness of sellers of such instruments, generally international banks and brokerage houses, to engage with a new and unfamiliar customer base
Some regulatory barriers

The adoption of several basic financial management practices is examined. The study provides estimates of the extent to which various business analysis and control, investment analysis and decision-making, and capital acquisition practices have been adopted. Many practices, such as net present value analysis, are not widely adopted by farmers. The relationship between the adoption of financial management practices and farm profitability is also examined. Results suggest that the adoption of financial management practices, such as using investment analysis techniques, significantly impacts farm financial performance.

The real question though is, are we using the lessons that we’ve learned? In today’s environment it is critical that we use all of the “lessons” on how to make sound loans and minimize risk while still serving the credit needs of agriculture. Increasing pressure to build business may have allowed lenders to become complacent, and rising farm incomes may have helped them avoid paying the price. There is nothing new or startling in the “lessons” chronicled here. They all call for attention to the basics, doing your homework on all aspects of the borrower’s operation. As competition intensifies among agricultural lenders, and borrowers are more susceptible to market pressures, agricultural lenders that follow these “lessons” will be the ones to survive and prosper.

Simple Road Maps and Blocks ahead.

1. Educate farmers on the use of commodity derivatives, and price knowledge.
The author would like to state an example of ‘Khargone’ a village in the border of Madhyapradesh where farmer’s where educated and based on future prices of cotton their cropping intention was re examined.

2. Taxation issue to be re –examined since hedging transaction is still treated as ‘speculation’, actually it is to be realized that “NOT” hedging is actually speculation.

3. Experts and policy makers to reach out to farmers as well as agro lenders and make them aware of the benefits of the commodity derivative industry.

4. Amendment to the FMC Act, which enable banks and financial institutions to participate directly in these markets.


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[1] What Does the Farmer really want ? Case for Agriculture revolution –3 Commodity Derivatives – Internal Publication Zone Equity Pte Ltd Singapore . Shravan Kumar,S.Venkataraghavan ,Nelson Lee 1997.

[2] Walk the Talk NDTV 2004 M.S.Swaminathan, Swaminathan et al , MS S Research Foundation