Rural and Agricultural Finance FAQs
- Who are the potential clients of rural and agricultural finance?
- What are their financial service needs?
- What is the ability of rural and agricultural finance clients to repay loans?
- Who supplies rural and agricultural finance?
- Why is it difficult for rural and agricultural businesses and households to get credit?
- What constraints and challenges do financial institutions supplying rural and agricultural finance face?
- How can technology be used to better reach and serve rural clients?
- What are the differences between traditional agricultural lending and microenterprise credit?
- How does rural and agricultural finance assist the rural poor?
- What roles do remittances and money transfers play in consumption smoothing and asset accumulation in rural areas?
1. Who are the potential clients of rural and agricultural finance?
Rural and agricultural finance clients are a complex and overlapping blend of rural households, small farmers, agribusinesses, and off-farm enterprises. These can broadly be categorized as:
- Off farm microenterprises and rural households (non agricultural) - Households not directly related to agriculture, as well as non-agriculture related businesses
- Farm and agriculture-related enterprises – Input suppliers, farmers, producer groups, local traders and processors
- Agribusinesses (non-rural) – Agri-processors, distributors, and exporters located in urban and peri-urban areas
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2. What are their financial service needs?
The financial service needs are broad and may include:
- Short term credit/working capital - for inputs, cash flow management, income smoothing
- Term credit - for fixed asset or land acquisition, leasing, inventory build-up
- Deposit and transfer services including domestic payment services and remittances - for cash flow management, risk mitigation, investment and asset-building
- Insurance products (health, life, weather)
Working capital is more readily available to rural enterprises than long-term credit or other financial services. It meets seasonal needs for inputs, labor, and production services. When timed correctly, working capital allows use of seed varieties, fertilizer, labor and other inputs that may lead to increased income. Working capital has limitations in that it is short-term financing for immediate needs of an enterprise. Also, very short-term loans (for instance, three months) for agricultural inputs are often too brief to allow repayment from the sale of seasonal crops. Without access to the flexibility of investment capital or other long- term sources of capital, enterprises cannot easily expand or upgrade their business or overcome unforeseen events.
Term funds finance capital improvements such as a new barn, storage facility, equipment or livestock expansion. Investments in these assets help businesses to grow and jump to the next level. Long-term credit is not readily available in rural areas, at least to smaller farms and enterprises.
Agriculture enterprises and rural households need other financial services. Deposit services enable rural households to manage crises (such as a sudden illness or a flood), to invest when opportunity strikes, or to pay for large expected expenses, such as school fees, a wedding, or a new roof. Cash flow management, money transfers and risk mitigation tools such as insurance are critical to weathering unforeseen costs like a family emergency, a natural disaster or crop failure.
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3. What is the ability of rural and agricultural finance clients to repay loans?
Sources of repayment for a typical client may include:
- Crop harvest or sale of animals
- Sale of processed product to buyer/exporter
- Microenterprise income
- Household members’ salaries and other earned income
- Remittances or domestic money transfers
- Sale of assets
Formal collateral (as opposed to collateral substitutes such as group guarantees) offered by RAF clients takes varied forms, including:
- Land
- Crop harvest
- Animals
- Farming equipment
- House
- Household appliance or personal assets
There are many potential problems in using these types of collateral. In some countries, land may not constitute an effective guarantee, either due to lack of land titling or judicial or political reluctance to enforce legal contracts (e.g., claiming land in compensation of non-payment on a loan) that would drive poor farmers away from their means of livelihood. Banks cannot use a house as collateral if the house cannot be seized (primary residence laws). In some countries the lack of lien laws or movable property registries may prevent the use of equipment as collateral.
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4. Who supplies rural and agricultural finance?
The main source of credit for many farmers and agribusinesses is other agribusinesses along the value chain including input suppliers, traders, and processors. Moreover, the clients’ own savings and credit from financial institutions continues to play a role in agricultural production.
Suppliers of rural and agricultural finance can be broadly categorized as:
- Value Chain Actors: exporters/wholesalers; processors; local traders and processors; producer groups; farmers; and input suppliers.
- Financial Institutions:
- banks (commercial, agricultural banks, state development banks)
- non bank financial institutions (NBFIs, commercial MFIs, other non-bank lenders, and leasing companies
- not-for-profit MFIs, which tend to work with poorer clients
- credit unions and agricultural cooperatives
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5. Why is it difficult for rural and agricultural businesses and households to get credit?
The development of microfinance and rural and agricultural financial markets often share similar environmental challenges such as an inhospitable policy, legal and regulatory framework, lack of adequate collateral, lack of registered credit history, lack of market information, and income variability among potential clients.
In addition, rural and agricultural markets have some unique characteristics that impede the supply of finance and the ability of rural households and firms to access the financial services they need.
- Weather risk: These are often correlated risks, affecting many people in an area by a single event, such as a drought, excessive rainfall, earthquake or other disaster. Rural households often rely on informal strategies to cope with risk, but these can break down when correlated catastrophic losses take place.
- Commodity risk: Agricultural enterprises are subject to uncertainties in the future market value of their produce and their future income, due to cost and price volatility in local, regional, and global markets.
- Seasonality: Rural farms and households are vulnerable to the cyclical or seasonal nature of the agricultural sector, even if their primary livelihood/economic base is not agriculture per se. Clients may face severe constraints in repaying a loan during certain times of the year (e.g., before the harvest comes in). Harvest season is a period of positive revenue while the planting season is characterized by a period of heavy spending and very little, if any, revenue generation. The toughest time is before the harvesting season, when liquidity is scarce and families in many regions need access to loans or other, non-agricultural sources of income.
- Geographic dispersion or distance to urban center/financial institution: Because clients live far from urban centers where financial institutions are often located, it increases the transaction cost for the borrower. These transaction costs include transportation costs and the opportunity cost of lost labor days.
- Poor physical infrastructure: Poorly developed roads or other public infrastructure can limit a borrower’s access to financial institutions in urban centers or increase the time it takes to get there, thereby increasing transaction costs.
- Social exclusion: Ethnic, caste and gender divisions might be more pronounced in rural areas. Hill tribes in India, for example, are relegated to working on low productivity land thereby diminishing their attractiveness to lenders.
The impact of these constraints on lenders are increased operating costs, greater information costs (owing to the heterogeneity among communities and farms) and higher real and perceived risks.
The high transaction costs and risk associated with agricultural production prevent financial institutions from playing a more active a role in the rural context. In urban areas, financial institutions are the primary suppliers of agricultural finance. However, in rural areas, agribusiness enterprises are the primary suppliers of finance.
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6. What macro-level constraints do financial institutions face in supplying rural and agricultural finance?
Lack of diversification of the rural economy and covariant risk: Covariant risk arises when many farms or households in one area are adversely affected by a single phenomenon such as drought, flood, epidemic, unexpected changes in world prices, macroeconomic crisis or civil conflict. This is distinct from individual risks, which randomly affect individual households. Individual risks relate more to individual illness, predation on livestock, old age, job loss, crime, etc.
Policy and regulatory constraints: An example of a policy and regulatory constraint that limits the recourse a lender has in the case of non-payment is a prohibition against repossessing real property from the poor. This is primarily a supply-side constraint.
Political meddling and crowding out: Politicians often use rural development programs to garner political support. Often accomplished through subsidized credit programs, this political meddling results in market distortions and crowds out potential financial institutions in the area.
The impacts of these constraints on lenders are higher operating costs, increased information costs (owing to the heterogeneity among communities and farms), and higher real and perceived risks.
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7. How can technology be used to serve rural clients?
Various technologies show promise for lowering the costs, managing the risks and increasing the efficiency of financial services in rural areas, including automated teller machines (ATMs), point-of-sale (POS) devices linked to smart cards, cellular phones, GIS mapping systems, and loan officers using personal digital assistants (PDAs).
ATMs, smart cards, and debit cards can provide flexible payment options and more convenient access to client accounts. They can also reduce branch infrastructure and employee costs, and facilitate financial services in areas with poor communications and electricity supplies.
PDAs can streamline the work of loan officers and speed decision making—as long as the financial institution’s loan analysis and client monitoring systems are sufficiently developed. The value of fast, field-level decisions can occasionally be enhanced by incorporating credit scoring into PDA systems.
Cellular phones can be used to check loan balances and repayment schedules. They have the potential to be used for stored-value transactions and to facilitate remittance transfers and payments if linked to point-of-sale devices and other payment points. Cellular networks may also be used for low-cost deposits and withdrawals if they are linked to local merchants and agents.
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8. What are the differences between traditional agricultural lending and microenterprise credit?
Many of the techniques used by microfinance organizations differ fundamentally from those of traditional agricultural credit methods or programs:
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Traditional Agricultural Lending
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Microenterprise Credit
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Borrower selection, credit decisions, product designs
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Credit decisions based upon projected income from future crop or livestock sales
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Credit decisions based upon current repayment capacity
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Typically uses feasibility studies to determine borrowers’ capacity to repay
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Often uses peer group information and past loan performance to determine creditworthiness of borrowers. Also, the track record with, and creditworthiness assessment of value chain players with whom the borrower might have an established relationship.
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Funds all or most of a targeted activity based on its merits and the borrower’s ability to carry it out
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Uses short-term, incrementally increasing loans to establish relationships with clients and lower default risk. Microloans tend to be far smaller than agricultural loans to households with the same income level
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Repayment tied to proceeds of the agricultural activity
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Frequent payments scheduled to take advantage of multiple income sources of a borrower’s household
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May provide agricultural finance to small groups, which often administer rotating loan funds
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Group mechanism often used to gather client information and enforce loan contracts, but retains loan administration function. This practice refers primarily to solidarity group lending, rather than individual lending or village banking (which devolve some administration functions to larger groups)
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Credit often linked to adoption of particular technologies, inputs, or marketing channels, which may require farmers to join associations or cooperatives
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Credit usually not tied to other services. Exceptions include programs that require compensating savings balances or provide minimal training on issues of social concern, such as maternal health or childhood nutrition
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Interest rates usually sets to be affordable within narrowly defined projections of returns on agricultural investments
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Interest rates set to fully cover costs, enabling microfinance institutions to engage in more operational activities— which lowers risk
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Relies on trained technical staff (agronomists, husbandry specialists), detailed analytical models or both to make loan decisions and monitor investment/ production programs
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Relies on staff trained in lending methodology, not on client activities
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Following through with borrowers
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Loan officers expected to spend most of their time developing and enforcing investment plans and ensuring production
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Loan officers expected to focus on building relationships with clients, enforcing repayment, and understanding the performance of farming households’ multiple economic activities
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Expends enormous effort to ensure that loans are used according to predetermined plans
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Understands that money is fungible and makes minimal attempts to control loan uses
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Tends to be more lax in the timing of payments, often assuming that farmers time their sales to achieve highest possible prices
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Expends great energy enforcing rigid repayment discipline
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Relies on extensive guidelines for multiple crops and livestock investment programs, expected cash flows, and repayment plans
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Relies on a few key indicators such as loan or payment amount to monitor repayment performance
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Uses more rudimentary loan tracking systems
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Develops efficient management information systems to facilitate immediate follow-up on late payments
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Source: Managing Risks and Designing Products for Agricultural Microfinance: Features of an Emerging Model (CGAP Occasional Paper No. 11 (2005)
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In recent years MFIs have been experimenting with methods that would enable them to partner with value chain players and move beyond traditional microfinance lending techniques as described above. Knowledge and experience is continuing to develop in this area. For more information on this topic, visit: www.value-chains.org
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9. How does rural and agricultural finance assist the rural poor?
Agriculture is still a leading economic sector, exporter, and source of livelihood in many developing countries, especially for the poor and for women. Rural livelihoods are often closely linked to agriculture. Financial services for the rural poor offer the same benefits of risk mitigation and income-smoothing as they do for urban and peri-urban microenterprises. Rural finance can also assist households in maintaining food security. Financial savings enable rural households to diversify and complement in-kind savings, while payment services enable them to cost-effectively send and receive money.
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10. What roles do remittances and money transfers play in consumption smoothing and asset accumulation in rural areas?
Income from national or international remittances is important for most developing economies, and it is disproportionately important for many rural areas where it may be the principal income source. Remittance monies can make significant contributions to consumption smoothing in poor households. Efficient mechanisms for money transfers are in large demand by the rural poor.
MFIs engaged in remittances to and from rural areas include the National Microfinance Bank of Tanzania, Uganda Microfinance Union for domestic transfers, Equity Bank in Kenya and Centenary Bank in Uganda for domestic transfers using Western Union as subagent, uBank for mineworkers in South Africa making transfers domestically and to Botswana, Lesotho, Mozambique, and Swaziland, Fonkoze in Haiti, Banco Solidario in Ecuador, PRODEM in Bolivia, and the ProCredit Bank in Kosovo.
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