Navigating Liquidity Issues Arising from Agricultural Lending
Safety & Soundness Update - July 2018
Published July 31, 2018 | July 2018 issue
There is no way around it—the agricultural environment has been challenging for several years, and there have been no signs of significant improvement. These challenges have affected banks whose customers depend on the sector. Our annual agricultural survey1 reported that many producers are experiencing compressed margins due to low commodity prices and relatively high fixed costs. Liquidity risk and credit quality are interwoven, as agricultural producers are often both loan and deposit customers. High commodity prices can lead to a surge in local bank deposits and a reduction in operating loan demand. The opposite is true in the current environment of low commodity prices and high input costs. As a result, we have observed that liquidity has been declining at some banks with agricultural loan concentrations, along with an increasing reliance on funding from wholesale and rate-sensitive sources. Operating in this low-margin environment provides a good reason for banks with agricultural concentrations to look at their practices to ensure that they remain appropriate for an increased level of liquidity risk.
This article covers policy guidelines with meaningful limits, a robust cash-flow forecast process, and the Contingency Funding Plan (CFP), three areas of liquidity risk management that are especially critical for banks with high agricultural loan concentrations and substantial reliance on wholesale funding.
A good policy always underpins a good liquidity risk management framework, and guidelines or targets are a key aspect of the liquidity policy. Banks want guidelines that are appropriate for their particular business model, so take time to consider your business risks and how they influence key measures. Important guidelines for banks with an agricultural concentration include unencumbered liquid asset reserves and unfunded loan commitments. Setting the guideline level to serve as a meaningful constraint is just as important as choosing the right guideline. At what point will you become uncomfortable, and does your board of directors agree? A good understanding of your risk appetite will support your bank in making difficult decisions when they arise—curtailing loan growth, for example—and will provide a consistent framework for discussing when exceptions are warranted.
Measuring liquidity risk is difficult because so much depends on what will happen in the future. This is where a good set of cash flow projections can help. Understanding the timing of your bank’s cash flows during expected business conditions and adverse conditions allows you to proactively manage liquidity. Banks will benefit by incorporating adverse assumptions related to their agricultural concentration into their cash flow projections. Consider including assumptions related to increased carryover debt, an associated decline in large deposits, and increased cash expenses due to workout plans such as carrying other real estate owned and cash needed to take out first liens. The key is to consider the specific risks posed by your bank’s agricultural concentrations when preparing stressed cash flow projections because customer relationships will simultaneously affect both the asset and the liability sides of your balance sheet. Monitoring cash flow projections will complement credit risk management practices that identify borrowers with projected cash flow problems.
Finally, it is always better to have a plan for how you will navigate a difficult event rather than making it up as you go. An actionable cash flow plan leverages your policy guidelines and cash flow projections to provide an early indication of risk as well as actions that will mitigate the risk to the bank. Knowing when to implement the plan is tricky and has consequences, so it is important to identify and document actionable early warning indicators (EWI). Good EWIs integrate quantitative and qualitative thresholds with actions to take at each threshold, such as proactively drawing on contingent funding sources or curtailing discretionary lending. Many of these actions may no longer be available or may become more costly in the midst of liquidity stress. Some examples of good EWIs include changes in core deposit outflow, increased reliance on rate-sensitive or volatile funding sources, and even qualitative indicators such as negative publicity concerning the bank or the local agricultural industry.
In conclusion, banks with agricultural concentrations have unique risks to their liquidity profile as well as asset quality and capital. Taking time to reevaluate your bank’s liquidity guidelines, cash flow projections, and cash flow plan will go a long way toward getting your bank ready for whatever difficulties this challenging agricultural environment brings our way.
1 Agricultural Credit Conditions Survey Good harvests, low prices for district farmers yet again, https://www.minneapolisfed.org/publications/agricultural-credit-conditions-survey/good-harvests-low-prices-for-district-farmers-yet-again