Financing Agriculture: Selected Approaches for the Engagement of Commercial Finance
Mike Coates and Robin Hofmeister (December 2014) | The following is a summary of Financing Agriculture: Selected Approaches for the Engagement of Commercial Finance, Chapter 3 in Financial Sector Development in Africa: Opportunities and Challenges. (Download PDF)
The chapter concentrates on the practical interface between the commercial financial sector and the growth of agricultural value chains. It is divided into three sections. The first section, Finance for All looks at the role of rural, savings-led financial service providers. The second section, Finance for Markets focuses on buyer and supplier finance, followed by the third section, Finance for Growth, which discusses commercial bank finance of agribusinesses. The authors argue that for African agriculture to grow, it will need access to the big balance-sheet lending of sophisticated and rapidly growing commercial banking systems in many African markets.
Finance for All
Finance for All In many African cities, commercial banking is growing rapidly. Banks are expanding their client outreach by investing in new branches, ATMs, and mobile technology. Most of these investments, however, are focused on provincial centers and areas with high population density, while rural areas remain largely underserved. In order to fill this gap, credit unions –also known as savings and credit cooperatives (SACCOs) –were created.
SACCOs are member-based financial institutions designed to capture and intermediate the savings of local communities or organized groups which are typically underserved by the mainstream financial sector. While they have many advantages, SACCOs often face governance issues and, as observed in Africa, they can become over-politicized and unable to operate effectively and sustainably. There are other rural financial service providers such as MFIs and rural banks, but they also tend to focus on the local salaried and merchant populations of villages or regional centers.
In order to overcome these limitations, rural financial service providers need long-term support to build their balance sheets through a broad-based approach to asset and liability management. This includes development of profitable products and strategies, increased savings, and staff development. Additionally, rural banks and credit unions need support to create strong networks and establish a shared centralized commercial banking operation or “apex bank.” Apex banks use economies of scale, improved cost of funds, and better marketing to compete with commercial banks and generate profits.
Finance for Markets
Finance for Markets Financial institutions are generally reluctant to lend to small agricultural producers in Africa because they are concerned that:
- small-scale agriculture is less profitable compared to other fast-growing sectors
- the operating and distribution model required to sustainably reach small producers is difficult, long-term, and requires large investments
- small producers have poor repayment rates and a low propensity to purchase other bank products
Given the reluctance of commercial banks to finance them, small agricultural producers turn to expensive informal credit sources to finance their short-term working capital needs. The gap between commercial banks and producers can be bridged via buyer and supplier finance.
Buyer and Supplier Finance
Buyer and supplier finance is the concept of providing formal short-term credit lines to agricultural producers. This line of credit is supplied by banks to pre-finance agricultural production. The credit is also intermediated by input suppliers and/or agrifood buyers within the same value chain. Buyer and supplier finance offers an alternative to conventional commercial bank finance and has been effectively implemented by major African value chains for many years, including commodities such as cotton, coffee, and cocoa.
A sign that a value chain may be ready for buyer and supplier finance is when there is a high prevalence of trade credit for pre-financing agricultural production mainly provided by input suppliers or buyers.
The advantages of this type of financing are the following:
- intermediary firm has close links with producers at the grassroots level, and the bank does not need to build infrastructure to reach this market
- intermediary firm has already identified a pool of creditworthy borrowers who have developed a repayment record
- intermediary firm ensures that the finance is spent by the borrower on productive inputs, rather than diverted into activities that may not realize repayment
- finance is a real trading advantage to the intermediary firm and can be used to solidify current banking relationships or to attract new customers from competitors
Both buyer and supplier finance rely on stable and professional relationships between producers and intermediary firms. If the intermediary firms are in a position of relative market power to the producers, they can ensure that the loan agreements are not violated.
In the buyer and supplier finance model, it is critical that banks identify suitable intermediary firms with which they have strong banking relationships. They also need to agree on the credit line terms and conditions and develop a simple application which the intermediary firm can use to “score” potential clients. Ideally, banks should be able to rely on the intermediary firm to screen applications and share a certain proportion of the risk.
Banks can manage risk arising from the relationship with the intermediary by mandating that producers receive payment for their produce in a dedicated account held with the bank. This would not only formalize producer financial activity, but it has been shown to enable producers to retain earnings over time.
Warehouse Receipt Finance
Another option for providing working capital to agricultural value chains is through warehouse receipts, which are used for commoditized produce, such as wheat, coffee, cocoa, or maize. This option may not be suitable for very small producers because they generally don’t have the volume of produce that makes such an operation cost-effective. The model is more adequate for higher levels of aggregation – such as in the trading environment or for agricultural cooperatives – and is most cost-effective for short-term finance.
In the warehouse receipt model, the produce is deposited in a warehouse by the owner and a receipt is issued against it. This receipt stipulates the quantity, quality, and type of produce deposited. Ownership of the warehouse receipt is transferable, making it suitable for collateral loans. This concept, however, only works under certain conditions, including:
- availability of good warehouse facilities so that both parties of the transaction can be confident that the produce is well protected and secure
- high levels of trust among the players, and particularly assurance that the warehouse operator will not release the produce to any party other than the true owner
- reliable inspection and grading services to ensure that the produce is of the precise type, quantity, and quality (hence, this only works for certain types of produce)
- produce should have a clear and open market price, and should not be highly perishable
- legal environment must be supportive of the bank’s right to quickly and unilaterally realize security in the event of default, usually by selling the warehouse receipt to a third party
- vibrant secondary market for warehouse receipts must be in place
Finance for Growth
Several studies on financing agricultural value chains in Africa have shown that a major difference among value chains is the presence of a strong agribusiness player at some point in the value chain. For overall value chain development, the authors advocate focusing on small and medium enterprises (SMEs) given that they are more likely to be able to create a true competitive advantage in terms of marketing, quality, and cost of production as compared to micro-enterprises. Large agribusinesses, on the other hand, can raise capital independently via stock markets.
Many agribusinesses in emerging markets tend to be undercapitalized because of insufficient investment or access to longer-term capital leads. Bankers are skeptical about lending to undercapitalized businesses, while business owners feel that banks should fund long-term growth. This gap in expectations results in minimal funding for agribusinesses.
Equity investment, which entails high risk, is often reserved for sectors with rapid growth potential, offsetting high risks with potentially high returns. However, in agriculture, equity investment varies across subsectors. Information is scarce and understanding of potential investors is limited. The lack of market depth to develop viable exit strategies for investments is also a potential inhibitor for investors.
To address these constraints, the authors recommend two interventions that the public and international development sectors can undertake to support agribusiness development:
- The establishment of a continental agribusiness investment pipeline would create a database of background information on “qualifying” firms that wish to solicit further investment. Financial data could be tracked over time, thereby giving investors an insight into the financial structure of the businesses. This could be overlaid on information relating to the investment climate in the country and some practical tips for success in the local investment environment. Access to the database could facilitate meetings between investors and registered companies, simply by providing up-to-date contact information.
- Offering tailored enterprise development services to selected agribusinesses would substantially reduce the cost of investment. Business development would work with investee firms to develop realistic, strategic, and business plans, with clear and measurable parameters of success, as well as principles of good governance and professional management.
The authors acknowledge that agricultural value chains in Africa are underinvested and in a great need for major injections of capital. They stress the importance of engaging commercial banks as they can leverage large balance sheets to finance growth. In addition, front-line rural and cooperative banks can expand outreach to small producers in collaboration with commercial banks. Supply chain finance and buyer credit can be used to finance working capital for producers. Other promising approaches include warehouse receipt finance and agricultural equipment leasing.
About AgriFin Technical Summaries
AgriFin Technical Summaries aim to make technical studies and reports on agriculture finance more accessible to practitioners, especially bankers and other professionals supporting the agriculture finance industry. The findings, interpretations, and conclusions expressed in the summarized publications do not necessarily reflect the views of AgriFin, neither does AgriFin guarantee the accuracy of the data included in the summarized publications.