2. Agricultural Finance(1)

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Chapter 10

AGRICUL TURAL FINANCE:

CREDIT CREDIT CONSTRAINTS AND CONSEQU ENCES

PETER J . BARRY

Dep artm ent of Agr icultu ral and Consumer Economics University of Illinois Urbana 1L

L1NDON J. ROBISON

Departm ent of Agricultural Economics Michigan State University East Lansing M1

Cont en t s

Abstract

1

Introduction

2 Financial characteristics of agriculture

3. Modern finance concepts

3.1. Age ncy relationships, adverse selection, and moral hazards

3.2. Resolv ing inform ation and incentive problem s

3.3. Incom plete contracting, property rights, and financial structure

3.4. Transaction cost econom ics

3.5. Free cash flow concept

4. Liquidity preference theory

5. Relationships in agricultural finance

5.1. Relationsh ip concepts

5.2. Evolv ing nature of relationships

5.3. Credit evaluation procedures

5.4. Man aging borro wers credit risks

5.5. Real estate leasing arrangements

5.6. Agrib usiness and trade financing

5.7. The role of social capital

6. Financial growth and intertemporal analysis

6.1. Grow th concepts

6.2. Emp irical mod eling

6.3. Objective functions

6.4. Time attitudes and life cycle models

6.5. Dyn amic analysis

6.6. Life cycle and intergenerational effects

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Handbo ok of Agricultural Economics Volume 1 Edited by B. Gardner and G. Rausser

2001 Elsevier Science B.I~ Al l rights reserved


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PJ Barry and L J Robison

7. Por t fol io theory and f inancia l analys is 539

7.1. Portfolio model 53 9

7.2. Business and financial risks 54 0

7.3. Risk and financial structure 54 1

8. Ag greg ate inves tment analys is 543

8.1. Investmentanalysis concepts 54 3

8.2. Early investment and tax policy studies 54 4

8.3. Investment capital structure and taxation 54 5

8.4. Investment and financing relationships 547

8.5. Investment sunk costs and risk 54 9

9. F inance eco no mic growth and the s t ructure of agr icul ture 549

10. Suppliers of f inancial capital 551

10.1. Introduction 55 1

10.2. Financing the agricultural sector 55 1

10.3. Types of agricultural lenders 55 2

10.4. Regulation of financial markets 55 3

10.5. Evolutionof financial markets 55 4

10.6. Implications or agricultural 1ending 55 5

10.7. Agricultural finance markets and institutions 55 5

10.8. Public credit policies 55 7

10.9. Financial stress in agriculture 559

11. Conc lud ing com men t s 560

References 561

bstrac t

The theory and methods used t o ana lyze the marke t manag ement and po l i cy e l ement s

of agr icul tura l f inance draw sub stant ia l ly on mo dern f inance concepts but wi th s ignif i -

cant ta i lor ing to the uniqu e character i s t ics o f agr icultura l sectors throu gho ut the wor ld.

Both developed and developing economies are considered in thi s chapter . Discussed

in deta i l are lender-b orrow er re la t ionships f inancia l grow th and inter temporal analys is

por t fol io theory and f inancia l ri sk inves tme nt analys is the f inancia l st ructure of agr i -

cul ture and pr ivate and publ ic sector suppl iers of f inancia l capi ta l . Oth er key i ssues

involve the l inkages betwe en investm ent and f inance and the extent of credi t ra t ioning

in agricul ture.

J E L c l a s si f i ca t i o n:

Q 1 4


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C h 1 0: Ag r icu l tu ra l F in a n ce 515

1 I n t r o d u c t i o n

Agr icu l tu ra l f inance focuses on the acqu i s i t ion and use o f f inanc ia l c ap i t a l by the ag r i -

cu l tu ra l sec to rs o f bo th deve loped and deve lop ing econom ies . F inanc ia l c ap i t a l i nc ludes

deb t , equ i ty , and l ea sed cap i ta l , a l though each o f the se sou rce s may inc lude numero us

fo rms . M uch o f the ana ly t i c a l work in ag r i cu l tu ra l f inance ha s cen te red on the concep t

o f c red i t a s a f i rm ' s bo r rowing capac i ty and i ts u t i l i z a tion in acqu i r ing and m anag ing

deb t c ap i t a l. A l so rece iv ing cons ide rab le a t t en tion a re the l e a s ing and re l a t ed pay m en t

ob l iga t ions fo r f a rmlan d and o the r types o f a s se t s, and the m anag em en t o f equ i ty cap i-

tal . Cha nnels fo r br inging outs ide eq ui ty capi ta l in to agr icul ture , how ever , a re not wel l

deve loped . Ou t s ide equ i ty ha s been d i s couraged f rom ag r i cu ltu ra l inves tmen t f inancing

in the pa s t by r i sk and in fo rm a t ion p rob lems , sm a l l fa rm s ize, and pub l i c po l i c ie s and

preferences .

Agr icu l tu ra l f inance inc ludes e l emen t s o f marke t s , mana gem en t , and po l i cy . The m ar -

ke t e l em en t cons ide rs the o rgan iza t ion and pe r fo rm ance o f in s t i tu tions func t ion ing a s

f inanc ia l in te rm ediar ies for the ag r icul ture sec tor , the t rading o f f inanc ia l ins t rume nts in

the f inanc ia l ma rke t s , and po ten t i a l r a t ion ing o f c red i t and o the r m arke t impe r fec t ions .

The m anag em en t e l emen t fo r ag r i cu l tu ra l f irms inc ludes inves tmen t ana lysi s , c ap it a l

s t ruc tu re, pe r fo rm ance m easu remen t , f inanc ia l p l ann ing , r i sk and l iqu id i ty managem en t ,

and e s tab l i shmen t o f r e l a t ionsh ips w i th financ ia l in t e rmed ia r i e s . These comp onen t s

m ay be eva lua ted a t the f i rm l eve l o r a t t he aggrega te , s ec to r l evel . The po l i cy e l emen t

cons ide rs the ro le o f gove rnmen ts in f i l l i ng gaps and re so lv ing impe r fec t ions in the

agr icul tura l f inance marke ts and in providing ta rge ted ass is tance to des igna ted rec ip i -

ents cons is ten t wi th soc ia l goa ls tha t a re unm et by pr iva te sources o f f inanc ia l capi ta l .

Agr icu l tu ra l f inance u t i li z e s key concep t s o f m ode rn f inance theo ry , adap ted fo r ap -

pl ica t ion to the uniq ue charac te r is t ics of agr icul ture . For e xam ple , the re la t ive ly smal l -

sca le , non -corpo ra te s t ruc ture of mo s t fa rm bus inesses prec ludes the is suances , t rading,

and r isk pr ic ing o f equi ty capi ta l shares in publ ic m arke ts . These s t ruc tura l charac te r is -

t ic s a l so re su l t in g rea ter emphas i s on repu ta t ion and in fo rm a l in fo rm a t ion exchanges in

the fo rm a t ion o f l ende r -bo r rower re l at ionsh ips . Consequen t ly , app roaches to inves tmen t

ana lys i s, op t ima l cap i t a l s t ruc tu re , and c red i t eva lua t ion p rocedure s mu s t a cc om mo da te

these an d o ther em pir ica l charac te r is t ics of agr icul ture . Th e uniq ue s t ruc tura l and infor-

m at ion charac te r is t ics of agr icul tura l sec tors have a lso led to the c rea t ion of spec ia l ized

f inanc ia l ins t i tu t ions , of ten publ ic ly autho r ized , opera ted , and subs id ized .

Th i s chap te r iden t if i e s and deve lops key concep t s o f ag r i cu l tu ra l f inance , by focu s ing

on the marke t , manage r i a l , and po l i cy e l emen t s c i t ed above . The s cope o f the chap-

t e r ' s ana lys i s inc ludes bo th deve loped and deve lop ing econom ies , a l though mos t o f the

app l i ca t ions a re d raw n f rom the deve loped eco nom y se tt ing . Sec t ion 2 o f th is chap te r

de l inea tes the k ey f inanc ia l charac te r is t ics of agr icul tura l f i rms in grea te r de ta i l . Sec-

t ions 3 and 4 iden t i fy key concep t s f rom m ode rn f inance theo ry and a sses s the i r appl i-

cabi l i ty to agr icul tura l finance . Inc lud ed is ins ight prov ided by p r inc ipa l -agen t theory ,

f inanc ial con t rac ting , and o the r e l emen t s o f o rgan iza t iona l e conomics . Sec t ion 5 ad -

dresses lender-bo rrowe r re la t ionships in ag r icul ture , inc ludin g the ro le of soc ia l capi ta l


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5 6 P J B a r r y a n d L J R o b i s o n

as a co m p l em en t to t he t r ad i t iona l r e l a t ions h i p concep t s . S ec t i ons 6 and 7 cons i de r , r e-

s pec t ive l y , f i r m g r ow t h and i n t e r t em por a l ana l ys is , and t he r o l e o f r i s k m an agem en t i n

ag r i cu l tu r a l f i nance . Sec t i on 8 f o cus e s o n agg r ega t e i nves t m en t ana l ysi s o f t he ag r i cu l-

tura l sec tor, inc lud ing fa rm ers inves tme nt behav ior , t ax pol ic ies , and capi ta l s t ruc ture .

Sec t i on 9 add r e s s e s t he r e l a t i ons h i p am ong f i nance , e conom i c g r owt h , and t he s t r uc -

ture of agr icu l ture . Sec t ion 10 focuses on suppl ie r s of f inanc ia l capi t a l to agr icu l ture ,

and Sec t i on 11 p r ov i des a con c l ud i ng pe r s pec t i ve on c r ed it , c r ed i t const r a in t s , and t he i r

c o n s e q u e n c e s .

2 F i n a n c i a l c h a r a c t e r i s t i c s o f a g r i c u l t u r e

Manage r s o f ag r i cu l t u r a l f i r m s r e l y heav i l y on deb t c ap i t a l i n com bi na t i on wi t h t he i r

ow n equ i t y cap i ta l t o f inance t he i r c ap i t a l ba s e , m e chan i ze and m ode r n i ze t he i r f a r m i ng

ope r a t i ons , condu c t m ar ke t i ng and p r od uc t i on p lans , and t o s e r ve a s a va l uab l e s ou r ce o f

l i qu id i t y in r e s pon d i ng t o r i s ks. I n d eve l op i ng econ om i es , deb t c ap i t a l is a l s o i m p or t an t

i n s m oo t h i ng cons um pt i on pa t t e r ns ove r t i m e . Read i l y ava i l ab l e c r ed i t ha s f ac i l i t a t ed

m a ny o f t he s i gn if i can t , l ong - t e r m chang es i n the f a r m s ec t o r - i nc r ea s i ng com m e r c i a l -

i za t ion , l a rger fa rm s izes , f ewer fa rms , grea te r spec ia l i za t ion , grea te r capi t a l in tens i ty ,

adop t i on o f new t echno l ogy , s t r onge r m a r ke t coo r d i na t i on , and o t he r s [ B a r r y (1995) ] .

M os t f a r m s t h r ou gho u t t he wor l d a r e s m a l l in s i z e , no t o r gan i zed as co r po r a t i ons ,

and have ow ne r s h i p , m a nagem en t , and r i s k bea r i ng concen t r a t ed i n the hands o f i nd i -

v i dua l f a r m er s and f a r m f am i l i e s [ Ba r r y e t a l . ( 1995) ; Ba r r y ( 1995) ] . Fa r m s i n deve l -

o p e d e c o n o m i e s g e n e r a l ly a r e m u c h l a rg e r t h a n t h e i r d e v e l o p in g e c o n o m y c o u n t er p a rt s .

A f ew f a r m s , e s pec i a l l y in d eve l op ed coun t r i e s , a re l a r ge i n s i z e , i ndus t r ia l i z ed in o pe r -

a t ions , and have com pl ex con t r ac t ua l a rr angem en t s f o r ow ne r s h i p , m a nagem en t , l abo r ,

and f i nanc i ng . Exam pl e s i nc l ude l a r ge - s ca le ca t t le f e ed l o t s , hog p r odu c t i on un i ts , pou l -

t r y and egg p r odu c t i on p l an ts , o r cha r ds , and o t he r s pec i a l t y c r op f a rm s .

D espi te the sm al l bus iness or ien ta t ion , agr icu l ture typica l ly i s a capi t a l - in tens ive in-

dus t r y wi t h i nves t m en t s i n f a r m l and , bu i l d i ngs , m ach i ne r y , equ i pm en t , and b r eed i ng

l i ve s t ock dom i na t i ng t he a s s e t s t ruc t u r e o f m os t t ypes o f fa r m s . F a r m r ea l e s t a t e com -

pr i se s ab ou t 70 pe r ce n t to 80 p e r cen t o f t o t a l a s s et s f r om y ea r t o yea r f o r the U. S . f a r m

s ec t o r ( U . S . De pa r t m en t o f Agr i cu l t u re ) . I nven t o r i e s o f l i ve s t ock , m ac h i ne r y , c r ops , and

o t he r non - r ea l - e s t a te f a r m a s s e t s gene r a l l y m ak e up 10 pe r cen t t o 15 pe r ce n t o f t o t a l as -

s e ts . The dom i nance o f f a r m r ea l e s ta t e t oge t he r wi t h t he r e l a t ive l y s m a l l ho l d i ngs o f

f inanc ia l asse ts indica tes the h igh c api ta l in tens i ty and low asse t l iquid i ty of the sec tor .

Hi gh cap i t a l in t ens i t y and l ow a s s e t l iqu i d it y , i n t u r n , c r ea t e t he dem and f o r l onge r - t e r m

f i nanc ing and c a r e f u l m a t ch i ng o f r epa ym en t ob l i ga ti ons wi t h p r o j ec t ed ca s h f l ows .

Th e f a r m s ec t o r deb t - t o - a s s e t r a t io t yp i ca l l y f a l ls i n a r e l a t i ve l y l ow r ang e co m par ed

t o deb t - t o - a s s e t r a t i o s i n m any o t he r e conom i c s ec t o r s . The f a r m s ec t o r deb t - t o - a s s e t

r a t io i n t he U. S . i nc r ea s ed s t ead i l y to r each t he 15 pe r ce n t to 18 pe r cen t range i n t he

1970s and t hen r o s e ab ove 20 pe r cen t i n t he m i d - 1980s , r e f l e c t i ng t he dec l i ne in f a r m

r ea l e s t a t e va l ue s t ha t cha r ac t e r i zed t h i s pe r i od . Subs equen t r educ t i ons i n f a r m deb t


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and r ecove r i e s i n f a rmland va lue s i n t he l a t e 1980s r e tu rned t he deb t - t o - a s se t r a t i o t o

the 15 pe r cen t t o 18 pe r cen t r ange , a r ange exh ib i t ed by o the r coun t r i e s w i th s imi l a r

c h a r a c t e r i s t i c s . T h e f a r m s e c t o r b a l a n c e s h e e t f o r C a n a d a i s c o n s i s t e n t w i t h t h e U . S .

e x p e r i e n c e , a l t h o u g h d e b t l e v e ls p e r f a r m a n d t h e a g g r e g a t e d e b t - t o - a s s e t r a t io r e m a i n e d

h i g h e r t h a n i n th e U . S . t h r o u g h t h e e n d o f t h e 1 9 8 0 s [ F r e s h w a t e r ( 1 9 8 9 ); B a r n a r d a n d

Gr imard (1995 ) ] . S imi l a r l y , t he ba l ance shee t f o r U .K . ag r i cu l t u r e i nd i ca t e s deb t - t o -

a s se t r a t i o s be low 10 pe r ce n t i n t he 1970s and i n the 10 pe r ce n t to 18 pe r c en t r ange fo r

t he 1980s [ Joh nson (1990) ] . I n Au s t r a l ia , t he f a rm sec to r r a t i o o f l ong - t e rm deb t t o to t a l

a s s e ts w a s l e s s t h a n 1 0 p e r c e n t f o r 1 9 9 0 - 1 9 9 3 [ B u f f ie r a n d M e t t e r n i c k - J o n e s ( 1 9 9 5 ) ].

T h e s e f a r m s e c t o r d e b t - t o - a s s e t r a t i o s a r e l o w r e l a t i v e t o t h o s e i n m a n y o t h e r e c o -

n o m i c s e c t o rs . F o r t h e A u s t r a li a n c a s e , B u f f ie r a n d M e t t e r n i c k - J o n e s ( 1 9 9 5 ) r e p o r t t h a t

t h e l o n g - t e r m d e b t - t o - a s s e t ra t i o i s t h e l o w e s t f o r a g r i c u l tu r e ( 1 0 p e r c e n t ), c o m p a r e d t o

t en o the r e con om ic s ec to r s ( t he th r ee h ighes t r a t i o s a r e 66 pe r ce n t f o r tr anspo r t , 52 pe r -

c e n t f o r c o n s t r u ct i o n , a n d 5 0 p e r c e n t f o r r e c r e a ti o n ) . P e t e r s e n a n d R a j a n ( 1 9 9 4 ) r e p o r t

a v e r a g e i n s ti t u ti o n a l d e b t - t o - a s s e t r a t io s f o r o v e r 3 , 4 0 0 s m a l l n o n - f a r m U . S . b u s i n e s s e s

o f 2 7 p e r c e n t f o r c o r p o r a t i o n s a n d 2 4 p e r c e n t f o r s o l e p r o p r i e t o r s h i p s a n d p a r t n e r s h i p s.

Fo r l a rge g loba l co rpo ra t i ons , s e l ec t ed yea r - end 1997 r a t i o s o f t o t a l l i ab i l i t i e s t o t o t a l

a s s e ts a r e 8 7 p e r c e n t f o r G e n e r a l E l e c t r ic C o m p a n y , 7 6 p e r c e n t f o r IB M , 6 5 p e r c e n t f o r

P e p s ic o , a n d 5 0 p e r c e n t f o r A m o c o O i l C o m p a n y . 1

Lo w d eb t - t o - a s s e t r a t i o s i n ag r icu l t u r e , r e l a t ive t o o the r s ec to r s o f t he econ om y , re f l e c t

t h e u s e o f c u r r e n t m a r k e t v a l u e s o f f a r m r e a l e s ta t e c o m p a r e d w i t h o r i g i n a l c o s t - a d j u s t e d

b o o k v a l u e s f o r d e p r e c i a b l e a s s e t s in o t h e r s e c t o r s [ I r w i n ( 1 9 6 8 b )] . T h e l o w e r r a n g e f o r

t he deb t - t o - a s se t r a t io , how eve r , is a l so cons i s t en t w i th t he heavy r e l i ance i n ag r i cu l t u r e

o n a n o n - d e p r e c i a b l e a s s e t s u c h a s f a r m l a n d i n w h i c h m u c h o f i t s e c o n o m i c r e t u r n

occu r s a s c ap i t a l ga in s o r l o s se s on r ea l e s t a t e a s se t s [Me l i cha r ( 1979 ) ; Ba r ry e t a l .

( 1 9 9 5 )] . S e v e r a l st u d ie s [ B a r r y a n d R o b i s o n ( 1 9 8 6 ); E l l i n g e r a n d B a r r y ( 1 9 8 7 ); L e e a n d

R a s k ( 1 9 7 6 )] h a v e s h o w n t h a t th e d e b t - c a r r y i n g c a p a c i t y o f n o n - d e p r e c i a b l e a s s et s ( f o r

e x a m p l e , l a n d) i s c o n s i d e r a b l y l o w e r t h a n t h a t o f d e p r e c i a b l e a s s e ts , u n d e r t r a d it i o n a l

l o a n r e p a y m e n t a r r a n g e m e n t s . L o w e r a g g r e g a t e d e b t - t o - a s s e t r a t io s f o r th e f a r m s e c t o r

a r e , the r e fo r e , l o g i ca l t o expec t .

T h e d o m i n a n c e o f r e a l e s t a te a m o n g t h e f a r m s e c t o r s a s se t s, a l o n g w i t h a l o n g - t e r m

g r o w t h i n r e t u rn s t o f a r m a s s e ts ( i n t e r ru p t e d i n t h e e a r l y 1 9 8 0s ) h a s m e a n t t h a t m u c h

o f t h e f a r m s e c t o r s t o t a l e c o n o m i c r e tu r n s h a s b e e n u n r e a l i z e d c a p i t a l g a in s o r , o n

occas ion , c ap i t a l l o s se s .

W he n sub j ec t t o fi nanc i a l ana ly s i s , t he f a rm sec to r s f inanc i a l s t a t emen t s i nd i ca t e a

r e a s o n a b l y s o l v e n t i n d u s t r y , b u t o n e t h a t e x p e r i e n c e s c h r o n i c l i q u i d i t y p r o b l e m s a n d

cash f l ow p re s su re s r e su l t i ng f ro m r e l a t i ve ly l ow , bu t vo l a t i l e , cu r r en t r a t e s -o f - r e tu rn t o

f a r m a s s e ts . T h e s e c h a r a c t e r i s ti c s m a k e t h e f a r m s e c t o r s d e b t - s e r v i c i n g c a p a c i t y a n d

c r e d i tw o r t h i n e s s v u l n e r a b l e t o d o w n w a r d s w i n g s in f a r m i n c o m e a n d l a n d v a l u e s.

1 The to tal liabilities for large corporations include contingent and deferred obligations in addition to out-

standing debt. They are not, thus, directly comp arable o the fa rm sector ratios, base d on farm d ebt alone.


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5 8 P J Barry and L J Robison

N on- f a r m i nco m e i s a ls o i m p or t an t t o t he l iqu i d i t y pos i t i on and f i nanc ia l we l l - be i ng

o f t h e f a r m s e ct or . T h e t o t a l a n n u a l n o n - f a r m i n c o m e e a r n e d b y f a r m o p e r a t o r s in t h e

U. S . ha s e xcee ded t o t a l ne t f a r m i ncom e s i nce the ea r l y 1980s . Mos t o f t he non- f a r m

i ncom e , how eve r , i s e a r ned by l a r ge num ber s o f ve r y s m a l l, pa r t - t im e f a r m s .

Th e do m i n ance o f r ea l e s t a te i n t he ag r i cu lt u r a l s ec t o r s t o t a l a s se t s and f a r m l and s

l ow d eb t - ca r r y i ng capac i t y have f o s t e r ed an ex t ens i ve f a rm l and l ea s ing m ar ke t . The

l e a s i n g o f f a r m l a n d b y f a r m o p e r a t o r s h a s b e c o m e a w i d e s p r e a d a n d c o m m o n l y a c -

cep t ed m e t ho d o f ga i n i ng con t r o l o f l and i n m any co un t r i e s , one t ha t i s e s pec i a l l y e f -

f ec t i ve f o r expand i ng f a r m s i ze . In 1992 , 43 pe r cen t o f t o t a l f a r m l and i n t he U. S . was

o p e r a t e d b y f a r m e r s u n d e r a r e n ta l a r r a n g e m e n t w i th l a n d l o r d s [ E c o n o m i c R e s e a r c h

S e r v i c e ( 1 99 4 )] . T h e r e m a i n i n g a c r e a g e w a s f a r m e d b y a n o w n e r - o p er a to r . T h e d o m i -

nan t f o r m o f r en t a l a r r angem e n t i n 1992 was a ca sh l e a s e ( 65 pe r cen t ) i n wh i ch f a r m er s

pa i d a f i xed o r f lex i b l e am o un t o f c a s h pe r a c r e to t he l andown er . Sha r e l e a s e s and o t he r

a r r angem en t s cons t i tu t e t he r em a i n i ng 35 pe r cen t o f t he to t a l a c r eage unde r l e a s e . The

ex t en t o f l e a s i ng and s ha r e r en t s d i f f e r s s ubs t an t i a l l y am ong r eg i ons and s t a t e s - s ha r e

l ea s ing i s h ighes t , f o r exam pl e , i n t he h i gh s o i l p r oduc t i v i t y a r ea s o f t he M i dw es t r eg i on

of t he U n i t ed S t a t e s , e s pec i a l l y in I l l ino i s ( 62 p e r cen t i n 1992) .

I n gene r a l , f a r m er s who l ea s e m os t o f t he l and t hey ope r a t e can have h i ghe r deb t -

t o - a s s e t r a t io s and ex pe r i enc e g r ea t e r cu r r en t r a te s o f r e tu r n t o f a r m a s s e t s and equ i t y

t h a n t h o s e w h o r e l y m o r e o n o w n e r s h ip . T h e s e m e a s u r e m e n t d i f f e r e n c e s r e f le c t d if f e re n t

accou n t i ng benchm ar ks i n t he p r o f i t ab i l it y and s o l venc y m eas u r e s f o r d i f f e r en t t enu r e

pos i t ions . T hes e f i nanc i a l r a t io s m ay a l s o d i f f e r subs t an t ia l ly am ong f a r m er s w i t h d i f f e r-

ences i n f a r m s i ze, age o f ope r a to r , and m a j o r t ype o f en t e r p ri s e . Re l i ance on l e a s ing and

t he r e s u l t i ng h i ghe r l eve r age r a t i o s m ay a l s o r e f le c t the l i fe cyc l e o f the f a r m ope r a t o r.

Yo unge r age c l a s s es o f f a r m er s l e a s e m o r e and t en d t o have h i gh e r l eve r age r a ti o s .

Agr i cu l t u r a l f ir m s f ace a co m p l ex ri s k env i r onm en t . I nc l uded a r e r is ks r e s u l t ing f r o m

l eng t hy b i o l og i ca l l y ba s ed p r oduc t i on , m a r ke t i ng ac t i v i t i e s , con t r ac t ua l r e l a t i ons h i ps

wi t h o t he r pa r t i e s , changes i n a s s e t va l ue s , and o t he r r e l a t ed i ncom e- gene r a t i ng ac -

t i v i t i e s . Fa r m er s a l s o f ace r i s ks a s s oc i a t ed wi t h f i nanc i a l l eve r age and unan t i c i pa t ed

changes i n i n t e r e s t r a te s , d eb t - s e r v i c ing r equ i r em en t s , and c r ed i t ava i lab i li ty . C ond i -

t ions i n t he gene r a l e cono m y , fi nanc i al m a r ke t s , gov e r nm en t po l i cy , and i n t e r na t i ona l

m ar ke t s m ay a l l i n f luence t he r is ks f ace d by f a r m er s . I n gene r a l , the co m bi ned e f f ec t s

o f bus i ne ss , f inanc i al , and co n t r ac t ua l r i sk s a r e h i gh f o r m os t t ypes o f f a rm s , t hus p l ac -

i ng a h i gh va l ue on r is k m an agem en t .

I n r e s p o n s e t o t h e s e ri sk s , f a r m e r s c a n e m p l o y a b r o a d r a n g e o f ri s k m a n a g e m e n t

p r ac t i c e s [ Pa t r i ck e t al . ( 1985) ] . Bes i de s p r oduc t i on and m ar ke t i ng r e s pons e s t o r is k ,

f i nanc i a l r e s pons es i nc l ude ho l d i ng l i qu i d a s s e t s , e s t ab l i s h i ng and m a i n t a i n i ng c r ed i t

r e s e r ves , ad j us t i ng l eve r age pos i t i ons , u t i li z ing i n s u r ance , an d m a i n t a i n i ng f l ex ib i l it y i n

t he f r eque ncy o f m ak i ng new cap i t a l i nves t m en t s o r r ep l ac i ng dep r ec i ab l e a s se t s. S om e

of t he f i nanc i a l re s pons es t o r i s k a r e d i r ec t l y i n f l uenced by pub l i c po l i c i e s, i nc l ud i ng

c r op i n s u r ance and pub l i c c r ed i t p r og r am s . F i na l ly , a num ber o f s tud i e s have s how n t ha t

r a t e s o f r e t u r n t o ag r i cu l tu r a l a s s et s hav e l ow, and i n s om e ca s e s neg a t i ve , co r re l a t i ons

wi t h r a t e s o f r e t u r n on va r i ous t ypes o f f i nanc ia l and non - f a r m a s se t s [ e .g . , Ba r r y ( 1980) ;


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Ch. 10: Agricu ltural Financ e 519

Ar t hu r e t a l. 1988) ; Youn g and Ba r r y 1987) ; Gu 1996) ] . Thus , the h i gh r i sks o f s t and -

a l one i nves t m en t s i n ag r i cu l t u r e m ay be s ubs t an t i a l l y r educed when t he s e i nves t m en t s

a r e ad ded t o w e l l - d ive r s i f ied po r t fo l i o s .

Th e cha r ac t e r i s t ic s o f t he ag r i cu l t u r a l s ec t o r j u s t de s c r i bed co m bi ne t o y i e l d a s i gn if -

i c an t and un i que s e t ti ng f o r t he s t udy o f ag r icu l t u r a l f i nance. The f ocus i s on a cap i t a l-

i n t ens i ve i ndus t r y i n wh i ch t he d om i nance o f f a r m r ea l e s t a te ha s b r oug h t li qu i d i t y

and de b t - ca r r y i ng cha l l enges a s w e l l a s s i gn i f ic an t r e l i ance on t he l e a s i ng o f f a r m l and

by m any f a r m er s . P r odu c t i on un i t s a r e m os t l y o f s m a l l e r s ca l e, a l t hough t he gap i s

wi de n i ng be t w een n um er ous s m a l l, pa r t -t i m e , l i m i t ed - r e s ou r ce f a r m s and t he r e la t i ve l y

f ew bu t m uch m or e econom i ca l l y s i gn i f i c an t , com m er c i a l - s ca l e ope r a t i ons . Bus i ne s s ,

f i nanci a l, and co n t r ac t ua l r i sk s i n ag r i cu l t u r e a r e h igh , bu t num er ous r i s k m anag em en t

op t i ons a r e ava i l ab l e , e s pec i a l l y f o r l a r ge r ope r a t i ons .

Thes e f ea t u r e s o f t he ag r i cu l t u r a l s ec t o r s have been t he ob j ec t s o f cons i de r ab l e r e -

s ea r ch i n ag r i cu l t u r a l f i nance . N um er ous f a r m - l eve l , r eg i ona l , and s ec t o r s t ud ie s hav e

p r ov i ded exp l ana t i ons o f , o r s t r a t eg i e s f o r i m pr ov i ng , f a r m f i nanc i a l s t r uc t u r e , f i r m

gr ow t h , i nves t m en t behav i o r , l i qu i d i ty and c r ed i t m anage m en t , l and va l ua t ion and co n -

t r o l, l e a s ing a r r angem en t s , and r i s k m an agem en t . P ub l i c po l i cy a l te r na t ive s f o r r e s pond-

i ng t o t he s e i s s ues have a l s o been i den t i f i ed and eva l ua t ed . Ot he r s t ud ie s have con s i d -

e r ed t he app r op r i a t e s t r uc t u r e , r egu l a t i ons , and m anagem en t o f f i nanc i a l i n s t i t u t i ons

p r ov i d i ng c r ed i t and o t he r f i nanc i a l s e rv i ce s t o t he ag r i cu l tu r a l s ec t o r unde r t he f i nan -

c i a l cha r ac t e r i s t i c s and cond i t i ons c i t ed above . Es pec i a l l y i m por t an t have been eva l u -

a t ions o f pub l i c c r ed i t p r og r am s . Sub s equen t s ec ti ons o f t h is chap t e r wi l l cons i de r the

appr oac hes an d f i nd ings o f m an y o f the s e s t ud ie s i n g r ea t e r de t a il .

3 M o d e r n f in a n c e c o n c e p t s

M ode r n f i nance t heo r y p r ov i des a r i ch pe r s pec t i ve on t he p r ov i s i on o f f i nanc ia l c ap i t a l

by t he f i nanc i a l m a r ke t s and i ts e f f ec t s on l en de r - bo r r ow er r e l a t ions h i ps i n ag r i cu lt u r e .

Th i s pe r s pec t i ve is ba s ed s t r ong l y on t he r e l a t i ve i n f o r m a t i on and i ncen t i ve pos i t ions

o f t he pa r t i e s t o a f i nanc i a l con tr ac t . I t con t a in s e l em en t s o f agenc y t heo r y , tr ans ac t i ons

cos t e conom i cs , i ncom pl e t e con t r ac t i ng , p r op e r t y and con t r o l r igh t s , and t he r e s u l t i ng

boun da r i e s o f a f ir m . I n t h i s pe r s pec t i ve , the f i r m i s v i ewed , a l te r na t ive l y , a s a nex us o f

con t r ac t s [J ens en and Meck l i ng 1976)] , a gov e r nanc e s t r uc t u r e [ Wi l l iam s on 1996) ] , o r

a l ocus o f a s s e t owne r s h i p and co n t r o l [ Ha r t 1988 , 1995)] , i n con t r a s t t o t he t r ad i ti ona l

cha r ac t e r i za t i on o f t he f i r m a s a p r od uc t i on f unc t i on [ Ha r t 1988) ] . Th e m od e r n pe r s pec -

t i ve ha s i m por t an t i m p l i ca t i ons f o r eva l ua t i ng t he f i nanc i a l pe r f o r m ance o f ag r i cu lt u r a l

f i rms and the f inanc ia l ma rke t s an d ins t i tu t ions se rv ing the agr icul tura l sec tor .

3 . 1. A g e n c y re l a ti o n s h ip s a d v e r s e s e l e ct i o n a n d m o r a l h a z a r d s

The p r i nc i pa l - agen t p r ob l em i s a gene r a l one t ha t app l i e s t o any con t r ac t ua l , i n t e r de -

pend en t re l a t ions h i p . Exam pl e s i n fi nance a r e the r e l a ti ons h i ps be t w een a l ende r t he


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P J Barry and L J Robison

p r i n c i p a l) a n d a b o r r o w e r ( th e a g e n t ), s t o c k h o l d e r s a n d m a n a g e m e n t , a n d l a n d l o rd s a n d

t enan t s . I n t he l ende r -bo r rower ca se , t he l ende r ha s en t ru s t ed t he bo r rower w i th t he

u s e o f lo a n f u n d s i n r e tu r n f o r t h e b o r r o w e r s p r o m i s e o f a s a f e a n d t i m e l y r e t u rn o f

t he funds , p lu s i n t e r e s t, a cco rd ing t o t he t e rms o f t he l oan con t r ac t . Ho we ve r , due t o

t h e a g e n t s s e l f- i n te r e st , i n f o r m a t i o n a l a s y m m e t r i e s , a n d u n c e r t a in e x p e c t a t io n s , b o t h

c o n t r a c t s a n d i n c e n t i v e a l i g n m e n t s b e t w e e n t h e p r i n c i p a l a n d a g e n t g e n e r a l l y a r e i n -

c o m p l e t e . A g e n c y c o s t s a t t r i b u t a b l e t o m o n i t o r i n g , b o n d i n g , a n d r e s i d u a l l o s s e s t h e n

a re i ncu r r ed i n s tr uc tu r i ng , adm in i s t e r i ng , en fo r c ing , an d adap t i ng con t r ac t s i n o rde r to

a l ig n i n c e n t i v e s , r e s o l v e i n f o r m a t i o n a l p r o b l e m s , a n d r e s p o n d t o u n c e r ta i n t ie s [ J e n se n

and Meck l ing (1976 ) ; Ba r ry e t a l . ( 1992 ) ] .

T h e l e n d e r - b o r r o w e r a n d l a n d l o r d - t e n a n t r e l a t i o n s h i p s a r e e s p e c i a l l y i m p o r t a n t i n

ag r i cu l t u r a l f i nance . I n a c r ed i t r e l a t i onsh ip , two bas i c conce rns o f t he ag r i cu l t u r a l

l e n d e r a r e ( 1 ) w h e t h e r t h e b o r r o w e r / a g e n t is r i sk i e r th a n b e l i e v e d w h e n t h e l o a n w a s

o r i g i n a te d ( a n a d v e r s e s e l e c ti o n p r o b l e m ) , a n d ( 2 ) w h e t h e r t h e b o r r o w e r w i ll t a k e o n

g r e a t e r ri s k s d u r i n g t h e t e r m o f th e l o a n t h a n w e r e o r i g i n a l ly a n t i c i p a te d ( a m o r a l h a z -

a r d p r o b l e m ) . T h e s e c o n d i t io n s a r e a t tr i b u ta b l e t o a s y m m e t r i e s in b o t h i n c e n t i v e s a n d

i n f o r m a t i o n b e t w e e n t h e l e n d e r a n d t h e f a r m b o r r o w e r . T h e b o r r o w e r is m o t i v a t e d b y

p ro f i t ab i l i t y and wea l t h accumula t i on , because he o r she sha r e s d i r ec t l y i n t he r e tu rns

( f avo rab l e o r un favo rab l e ) e a rned b y t he l oan p roceeds . I n co n t r a s t , the l ende r i s r e -

s t r ic t ed t o t he f i xed re tu rns o f t he l oan fu nds p lu s i n t e r e s t, a s e s t ab l i shed i n t he l oan co n -

t ra c t, a l t h o u g h a d d i t io n a l b e n e f i ts m a y c o m e f r o m g r o w t h o v e r ti m e i n a s u c c e s s f u l b o r-

r o w e r s f i n a n c i n g n e e d s . T h u s , i n e v a l u a t i n g a b o r r o w e r s c r e d i tw o r t h i n e s s , t h e l e n d e r

em pha s i ze s l oan r epayab i l i t y and s a f e ty - t ha t is , s e l f - l iqu ida t i ng and a s se t -ge ne ra t i ng

loans - wh i l e the bo r ro we r focus e s on p ro f i t ab i l it y and wea l t h .

A s y m m e t r i c i n f o r m a t i o n i s a ls o d i r e c t ly i n v o l v e d in t h e a g e n c y r e la t i o n s h ip b e c a u s e

t h e l e n d e r m a y l a c k i n f o r m a t i o n a b o u t t h e b o r r o w e r s g o a l s a n d a c t i o n s , a s w e l l a s

a b o u t t h e ri s k s o f t he p r o j e c t s b e in g f i n a n c e d . F a r m b o r r o w e r s s h o u l d k n o w m o r e a b o u t

t he i r p roduc t i v i t y , bus ine s s cha r ac t e r i s t ic s , f i nanc i a l pos i t i on , and r ep ay m en t i n t en t i ons

t h a n d o l e n d e r s , a n d m u c h o f f i n a n c i a l p l a n n i n g a n d l o a n d o c u m e n t a t i o n i s i n t e n d e d

t o c o n v e y t h is i n f o r m a t i o n f r o m b o r r o w e r s t o l e n d e r s. L e n d e r s d o s p e c i a li z e i n l e n d in g

a n d r e l a t e d i n f o r m a t i o n p r o c e s s i n g , a n d t h e y m a y h a v e a b r o a d e r p e r s p e c t i v e o n c r e d i t

t r ansac t i ons t han do bo r rower s . Howeve r , t he i n t en t i ons , ab i l i t i e s , and expe r i ences o f

i n d i v id u a l b o r r o w e r s a r e w h a t m o t i v a t e l o a n p e r f o r m a n c e .

A d v e r s e i n c e n t i v e s f o r b o r r o w e r s m a y a l s o a r i s e b e c a u s e t h e y d o n o t b e a r t h e f u l l

c o n s e q u e n c e s o f th e i r a c ti o n s . A s l e v e r a g e i n c r e a se s , t h e c o n s e q u e n c e s o f m o r e o f t h e

bo r row er s a c t i ons t ha t le ad t o de f au l t a r e bo rne by t he l ende r [S t i g l it z ( 1985 ) ] . A bo r -

rower , t hen , ha s an i nc r ea s ing i ncen t i ve t o t ake r i sk i e r a c t i ons and t o emp loy a go - fo r -

b rok e a t ti t ude [R ob i son e t al . (1987 ) ; Fos t e r and R auss e r ( 1991 ) ] t ha t i nc r ea se s t he cos t

o f f i n an c i n g f o r th e l e n d e r a n d i n c r e a s e s t h e l e n d e r s l ik e l i h o o d o f b e c o m i n g a n o w n e r

o f t he bo r r ow er s a s se t s. T he l ende r , i n t u rn , ha s an i nc r ea s ing i ncen t i ve t o con t ro l t he

b o r r o w e r s a c t i on s .

T h e s e i n s ig h t s f r o m f i n an c e t h e o r y h a v e h e l p e d t o g u i d e t h e r e s e a r c h a g e n d a i n a g r i -

cu l t u r a l f inance . S tud i e s have focuse d c lo se ly on t he i n fo rm a t ion - in t ens ive , pe r so na l i z ed


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521

r e l a t ions h i ps t ha t cha r ac t e r i ze t he a r r angem en t s be t w een ag r i cu l tu r a l l ende r s and t he i r

bo r r ow er s , i nc l ud i ng t he l ende r s p r oced ur e s f o r eva lua t i ng and m on i t o r i ng c r ed i t wor -

t h i ne s s . Ra t i ona l i z i ng t he s pec i a l i z a t i on o f m any l ende r s i n f i nanc i ng ag r i cu l t u r e i s a

na t u r a l ou t g r ow t h o f t he s ec t o r s s ou r ce s o f r is k , s m a l l bus ine s s o r i en t a t ion , and cap i t a l

i n tens i ty . S i m i l a r ly , s t ud i e s t ha t cons i de r t he ch ang i ng m o t i va t ions o f f a r m er s a s d eb t

l eve l s and f i nanc i a l adve r s i t ie s i nc r ea s e have h e l ped t o e xp l a i n t endenc i e s t ow ar d go -

f o r - b r ok e behav i o r , s t r ingency i n l oan con t r ac t s , and i n t ens e m on i t o r i ng a r r angem en t s

by ag r i cu l tu r a l l ende r s. T hes e i s s ues and r e l a t ed s t ud ie s a r e f u r t he r deve l oped be low.

3 2 R e s o l v i n g i n f o r m a t io n a n d in c e n t iv e p r o b l e m s

Len de r s and bo r r ow er s m ay u t i li z e ex t ens i ve p r ac t i c e s t o im p r ove i ncen t i ve a l ignm en t s

and r e s o l ve i n f o r m a t i on p r ob l em s [ Mi l l e r e t a l. ( 1993) ] . D i f f e r en t ia l l oan p r i c i ng ba s ed

on r i s k - ad j us t ed i n t e r e s t r a t e s is on e l ende r r e s pon s e t o t he adve r s e s e l ec t i on p r ob l em

[St ig l it z and Weiss (198 3) ] . Credi t r a t ioning , ins t i tu t iona l advers i t i es , and ma rke t fa i lure

a r e pos s i b l e r e s u l t s o f s eve r e c r ed i t r a ti on i ng . U s i ng r i s k - ad jus t ed i n t e r e s t ra t e s wo u l d

y i e l d a m or e d i s pe r s ed d i s t ri bu t ion o f ri s ky bo r r ow er s and l ow er l end i ng r is ks on ave r -

age , t hus r educ i n g t he adv e r s e s e l ec t ion p r ob l em s . Ad j us t ing i n t e re s t ra t e s f o r r is k p r e -

s um es t ha t s u f f i c ien t in f o r m a t i on is ava i lab l e t o e f f ec t i ve l y d i s t ingu i s h am ong t he r i s k

c l a s si fi c a ti ons . Thus , i n f o r m a t i on co l le c t i on , p r oces s i ng , an d m on i t o r i ng by l ende r s a r e

i m po r t an t con t ri bu t i ons to t he r e s o l u t i on o f agenc y cos t p r ob l em s be f o r e and a f t e r t he

loan co nt rac t i s es tab l i shed .

M a r k e t s ig n a l in g i s a n o t h e r m e c h a n i s m w h e r e b y b o r r o w e r s a n d l e n d e r s re s p o n d t o

t he p r ob l em s o f a s ym m et r i c i n f o r m a t i on . Mar ke t s i gna l i ng s ugges t s t ha t one o r m or e

o f t he m ar ke t pa r t i c i pan t s ( t he l ende r o r t he bo r r ower ) convey add i t i ona l i n f o r m a t i on

t o o t he r m ar k e t pa r t ic i pan t s ( t he bo r r o w er o r the l ende r ) abou t the l eve l s o f and va l ue

p l aced o n c r ed i t wor t h i ne s s . E f f ec t i ve f i nanc i a l a ccoun t i ng s ys t em s m a i n t a i ned by c r ed -

i t wor t hy bo r r ow er s p r ov i d e a d i s ti ngu i s h i ng s i gna l be t we en h i gh and l ow c r ed i t ri s k s,

a n d t h e y p r o v i d e f o r m o n i t o r i n g o f b u s i n es s p e r f o r m a n c e o v e r ti m e . B e c a u s e c e r ti fi e d o r

aud i t ed accou n t s a r e u s ed r e l a t i ve l y l it t le i n ag r i cu l tu r e , l ende r s m u s t em pl oy t he i r ow n

expe r t i s e i n d is t ingu i s h i ng am ong f a r m er s f i nanc ia l pe r f o r m ance . Ag r i cu l t u r a l bo r r ow -

e r s m ay a l so und e r t ake m ana gem en t p r ac t ic e s t ha t d i s t ingu i s h t hem f r o m t he i r pee r s and

h i gh l i gh t un i que s k i ll s and l eve l s o f p r oduc t i v i ty . Ex am pl e s i nc l ude t he u s e o f f u t u r e s

and op t i ons con t r ac t s to m anag e r is ks , p r oduc i n g s pec i a l t y c r ops , adop t i ng new p r oduc -

t i on and t e l ecom m uni ca t i on t e chno l og i e s , advan ced l eve ls o f educa t i on , and l e ade r s h i p

r epu t a t i ons i n l oca l com m uni t i e s .

Ex t ens i ve f i nanc ia l con t r ac t i ng by l end e r s i nvo l ves p r ov i s i ons i n a l oa n co n t r ac t in -

t ended t o add r e s s po t en t i a l adve r s e s e l ec t i on and m or a l haza r d p r ob l em s [ Sm i t h and

War ne r ( 1979) ] . Thes e non- p r i ce m e t hods i nc l ude co l l a t e r a l r equ i r em en t s , l oan r epay -

m en t upon dem and p r ov i s i ons , r epo r t i ng r equ i r em en t s , pe r f o r m ance s t anda r ds , s a l e s

r e s t ri c t ions , cons t r a i n t s on add i t i ona l bo r r owi ng , i n s u r an ce r equ i r em e n t s , de f au l t pena l -

t ie s , and f o r ec l o s u r e cond i ti ons . Becau s e t he con t r ac t i ng cos t s gene r a l l y a r e bo r n e by

t h e b o r r o w e r , h i s o r h e r r e s p o n s e s t e n d t o r e d u c e a s y m m e t r ic i n f o r m a t i o n p r o b le m s a n d


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522

P.J. Bar ry and L.J. Ro bison

a l i gn t he bo r r o we r s a c t ions w i t h t he goa l s o f t he l ende r . In add i t ion , t he f i nanc i a l m a r -

ke t d i s c i p l ine s bo r r ow er s t h r ough t he r i s k o f non - r ene wa l o f l oans i f agency cos t s a r e

excess ive [St ig l i t z and Weiss (1983) ] .

T h e c r e a ti o n o f m a r k e ts f o r e x c h a n g e o f f in a n c ia l i n f o rm a t i o n is a n o t h e r m e c h a n i s m

f o r r e s pond i ng t o t he p r ob l em s o f a s ym m et r i c i n f o r m a t i on . Cr ed i t - r a t i ng com pan i e s ,

f o r exam pl e , s pec i a l i z e i n co l l e c t i ng and d i s s em i na t i ng i n f o r m a t i on abou t pa r t o f t he

c r ed i t wor t h i ne s s o f ag r i cu l t u ra l bo r r ower s . C o l l a te r a l con t r o l com pa n i e s w i ll m on i t o r ,

cont ro l , and va l ida te the s t a tus of spec i f i c asse t s (e .g . , s tored gra in , an imals in l a rge

ca t t l e f eed l o t s ) p l edged t o s ecu r e a l oan ag r eem en t . F i e l d s e r v i c i ng com pan i e s , wh i ch

m ay i nc l ude banks o r o t he r f i nanc i a l i n s t i t u t i ons , wi l l s e r v i ce ag r i cu l t u r e r ea l e s t a t e

l o an s , m a n a g e r e p a y m e n t s , a n d m o n i t o r l o a n p e r f o rm a n c e . W r i tt e n o r o r a l re f e r e n c e s

p r o v i d e d b y i n d iv i d u al s a b o u t o t h er s a r e a c o m m o n l y u s e d f o r m o f m a r k e t i n f o rm a -

t i on , and l ende r s o f t en a r e wi l l i ng t o exchange a t l e a s t s om e i n f o r m a t i on abou t t he i r

cus t om er s i n o r de r t o f ac i l i ta t e t he f unc t i on i ng o f t he i r r e s pec t i ve m ar ke t s .

I f i n f o r m a t i on p r ob l em s a r e s eve r e enough , pub l i c po l i c ie s and i n s t it u t iona l r egu l a -

t io n s m a y b e d e v e l o p e d t o e n h a n c e m a r k e t p e r f o r m a n c e . S u c h a c ti o n s m i g h t b e j u s ti -

f i ed i f the m ar ke t i n ques t i on s e r ves t he pub l ic i n t e r e s t and i f non - go ve r n m en t r e s o l u -

t ions t o i n f o r m a t i on de f i c i enc i e s a r e i ne f f ec t ive . Exam p l e s i nc l ude f i nanc ia l r epo r t i ng

r equ i r em en t s f o r co r po r a t e f a rm s , d i s c l o s u r e s o f pub l i c o f f e r i ngs to f i nanc i a l r egu l a to r s ,

t r u t h - in - l end i ng and adv e r t is i ng r equ i r em en t s , and g ove r nm en t s pons o r s h i p o f f i nanc ia l

i n s ti tu t i ons and l oan p r og r am s .

3 .3 . I n c o m p l e t e c o n tr a c t in g p r o p e r t y ri g ht s a n d f i n a n c i a l s t r u c tu r e

A f i r m s f i nanc i a l s t r uc tu r e can a l s o be exa m i n ed us i ng t he i ncom pl e t e con t r ac t ing ap -

p r oach i n wh i ch t he a l l oca t ion o f r i s k and co n t r o l am o ng a l t e rna t i ve c l a s se s o f i nves to r s

i s a key f ocus [ Ha r t (1988) ; Be r g l o f ( 1990) ; A gh i on an d B o l t on ( 1992) ] . De b t and eq -

u i t y a r e t he s t anda r d f i nanc ia l in s t r um en t s , bu t t hey a r e d i s t i ngu i s hed no t on l y by t he i r

r e l a ti ve c l a i m s on t he f i r m s a s s e ts and ea r n i ngs , bu t a l s o b y t he con t r o l ri gh t s a s s oc i a t ed

wi t h each t ype o f f inanc i a l c l a i m - w he r e t he r e s i dua l ri gh t s o f con t r o l ( t hos e no t de s ig -

na t ed by t he f i nanc i a l con t r ac t o r by l aw) a r e s yno nym ous wi t h owne r s h i p . M or e s pec i f i -

ca l ly , t he a l l oca ti ons o f con t r o l and own e r s h i p unde r th i s app r oach a r e s t a t e - de pe nd en t -

unde r no r m a l cond i t i ons , equ i t y ho l de r s ow n and con t r o l the f i r m s a s s e ts , a l t houg h u l -

t i m a t e con t r o l is d e t e r m i ne d by t he t ype o f eq u i t y ( e .g . , vo t ing ve r s us n on- vo t i ng s t ock ,

p r e f e r r e d ve r s us com m on s t ock , l im i t ed ve r s us gene r a l pa r tne r s ) . Unde r ex t r em e adve r -

s ity , how eve r , f inanc i a l con t rac t s a r e de s i gned s o t ha t ow ne r s h i p an d con t r o l r eve r t to t he

deb t ho l de r s ( acco r d i ng t o s en i o r i t y and s i ze o f c l a im s ) . De b t c ap i ta l , t hus , r ep r e s en t s a

f o r m o f c o n t i n g e n t o w n e r s h ip o f t h e f i rm .

Unde r t he p r ope r t y r i gh t s app r oach , t he t e r m s o f t he r e s pec t i ve t ypes o f f i nanc i a l

c l a i m s l og i ca l l y m u s t r ep r e s en t m or e t han t he n eed f o r ex t e r na l f unds an d t he l eve l o f

com pens a t i on f o r t he u s e o f t he s e f unds . Unan t i c i pa t ed con t i ngen c i e s r a i s e open ques -

t ions abo u t who wi l l con t r o l t he f i rm unde r a l te r na t ive pe r f o r m ance cond i t i ons and how

cas es o f d i s pu t e and f i nanc ia l d is t re s s a r e u l t i m a t e l y r e s o l ved . Suc h co n t i ngenc i e s a r e


11/59

Ch 10: Agricu ltural Finance

523

too num ero us and t oo va r i ed t o fu l l y an t i c ipa t e i n a wr i t t en con t r ac t . Thus , co n t r ac t s a r e

n e c e s s a r i l y in c o m p l e t e i n t h a t t h e y d o n o t s t i p u l at e t h e c o n t r a c ti n g p a r t i e s o b l i g a t io n s

a n d a c t i o n s i n e v e r y e v e n t u a li ty . I n c o m p l e t e n e s s g i v e s ri s e t o t h e n e e d t o a l l o c a t e c o n t r o l

i n s i tua t i ons no t c ove red by t he i n i ti a l con t r ac t - t ha t is , the a l l oca t i on o f the r e s idua l

r i gh t s o f con t ro l .

I n e f f e c t, t h e i n c o m p l e t e c o n t r a c t i n g a p p r o a c h s u g g e s t s t h a t th e p a r t i e s t o t h e c o n t r a c t

mus t de t e rmine a t t he ou t se t who i s be s t su i t ed t o con t ro l t he f i rm in va r ious s i t ua t i ons

a n d w h a t p e r f o r m a n c e l e v e l s w i ll s i g n a l t h e n e e d f o r a t r a n s f e r o f c o n tr o l . G i v e n t h i s

c o n t i n g e n t a l l o c a t i o n o f c o n t r o l , th e s h a r in g o f r e tu r n s t r e a m s i s d e s i g n e d t o p r o v i d e t h e

a p p r o p r i a t e i n c e n ti v e s f o r t h e e x e r c i s e o f e f fo r t b y t h e p a r t ie s c o m m e n s u r a t e w i t h t h e i r

r e s p e c t i v e r a n g e s o f c o n t r o l [ B e r g l o f ( 19 9 0 ) ]. T h a t i s , th e p a r t y h o l d i n g r e s i d u a l c o n t r o l

r i g h ts o v e r a s p e c i f i e d r a n g e o f s t a te s s h o u l d b e a r t h e r i s k a n d r e a p t h e e x p e c t e d r e tu r n s

a s soc i a t ed w i th dec i s ions i n t he se s t a t e s . Th i s pa r ty ( t he equ i ty ho lde r ) w i l l exe rc i s e

e f f o r t c o m m e n s u r a t e w i t h t h e a n t i c i p a t e d r e w a r d s . I n l e s s f a v o r a b l e s t at e s, h o w e v e r , t h e

r e w a r d s t o s u c h e f f o r ts d i ss i p at e , a n d g o - f o r - b r o k e a ct i o n s b y t h e e q u i t y h o l d e r , w h o s e

f i n an c i a l c la i m s a r e s u b s t a n t ia l l y d i m i n i s h e d , m a y y i e l d a d v e r s e e f f e c t s t h a t a c c r u e m o r e

to t he deb t ho lde r . Thus , i t i s l og i ca l a t t h i s po in t f o r t he r e s idua l r i gh t s o f con t ro l ,

a s soc i a t ed w i th owne r sh ip , t o sh i f t t o t he l ende r so t ha t he o r she can exe r t app rop r i a t e

e f fo r t t o p ro t ec t t he deb t c l a ims . I t is a l so l og i ca l f o r t he l ende r t o exe rc i s e m ore s t r i ngen t

p r o v i s i o n s o f f i n a n c i a l c o n t r a c t s t h a t i n c r e a s i n g l y c o n s t r a i n t h e r a n g e o f m a n a g e r i a l

cho i ce s ava i l ab l e t o the eq u i ty ho lde r .

3 4 T r a n s a c t i o n c o s t e c o n o m i c s

E l e m e n t s o f t r a n s a c t io n c o s t e c o n o m i c s a l so a p p l y t o a f i r m s a n t i c i p a te d f i n an c i a l

s t ruc tu r e and r e l a t i onsh ips w i th supp l i e r s o f fi nanc i a l c ap i t a l. Acco rd ing t o W i l l i amso n

(1996) , t r ansac t i on cos t s a r e i ncu r r ed i n d r a f t i ng , nego t i a t i ng , gove rn ing , s a f egua rd ing ,

a n d a d a p t i n g t h e t e r m s o f a g r e e m e n t s . T h e t r a n s a c t i o n c o s t s a r e c lo s e l y r e la t e d t o a g e n c y

c o s t s, a l t h o u g h p l a c i n g m o r e e m p h a s i s o n e x - p o s t g o v e r n a n c e s t ru c t u re s v e r s u s t h e e x -

a n t e f o c u s o f a g e n c y t h e o r y a n d o n t r a n s a c t i o n c h a r a c t e r is t ic s v e r s u s t h e c h a r a c t e ri s t ic s

o f p r i n c ip a l s a n d a g e n t s [ W i l l i a m s o n ( 1 9 9 6 ) ]. T h e c h o i c e o f g o v e r n a n c e s t r u c tu r e f o r

c o o r d i n a t i n g a v e r t i c a l s y s t e m a n d d e t e r m i n i n g t h e b o u n d a r i e s o f fi r m s th e n f o c u s e s o n

t h e m i n i m i z a t i o n o f t r a n s a c t io n c o s ts , b a s e d o n t h e c h a r a c t e r i st i c s o f t h e t r a n s a c ti o n s

a n d t h e w o r k e f f o rt s o f t h e r e s p e c t i v e p a r ti e s .

W i t h in t h i s t r a n s a c ti o n c o s t f r a m e w o r k , W i l l i a m s o n ( 1 9 9 6 ) s u g g e s t s t h a t t h e d e g r e e

to wh ich a s se t s a r e spec i a l i z ed t o va r ious ac t i v i t i e s i s an impor t an t de t e rminan t o f a

f i rm s f inanc i a l s t r uc tu r e . I n h i s v i ew , i nves tm en t s w i th l ow a s se t spec i f i c i t y a r e mo re

s u i ta b l e f o r d e b t f in a n c i n g b e c a u s e o f t h e i r e a s i e r r e d e p l o y m e n t ( o r r e - m a r k e t a b i l it y ) .

Re -marke t ab i l i t y i s a p r e f e r r ed a t t r i bu t e o f a s se t s p l edged a s co l l a t e r a l t o s ecu re a

loan . I n con t r a s t , equ i ty f i nanc ing i s mo re l i ke ly fo r re l a t i onsh ip - sp ec i f i c a s se ts . Re -

m a r k e t a b i l i ty o f s u c h a s s e t s i s l o w e r a n d t h e r e t u r n s t o s p e c i a l i z e d a s s et s a r e m o r e v u l -

n e r a b l e t o o p p o r t u n i s t i c r e n t - s e e k i n g b y o t h e r c o n t r a c t i n g p a r t i e s . T h u s , W i l l i a m s o n

(1996) a s se r t s t ha t a f i rm s u se o f de b t r e l a t i ve t o equ i ty cap i t a l i s i nve r se ly r e l a t ed


12/59

5 4 P J Barry and L J Robison

t o t he deg r ee s o f s pec i f i c i t y o f a s s e t s owned o r con t r o l l ed by t he f i r m . Thes e t r ans -

ac t i on cos t concep t s m a t ch we l l wi t h t he t endency f o r h i gh l y s pec i a l i z ed ag r i cu l t u r a l

a s s et s ( e . g . , bu i ld i ngs , co n f i nem en t p r odu c t i on t e chno l og i e s , i r ri ga t ion s ys t em s ) t o hav e

h i ghe r equ i t y cap i t a l r equ i r em en t s t han is t he ca s e f o r m or e m ar ke t ab l e m ach i nes , l i ve -

s t ock , com m o di t i e s , and pe r haps eve n fa r m l and .

3 5 Free cash flow concept

J ens en s ( 1986) f r ee ca s h f l ow conc ep t a l so ha s app l i cab i li t y t o ag r i cu l t u r a l f i nance .

Th e f r ee ca s h f l ow concep t sugges t s tha t m an age r s ( agen t s) o f f ir m s w i t h exces s ca s h

f lows and abundan t f i nanc ia l a ss e ts m ay exe r c i s e m anage r i a l l axnes s, devo t e i n su f f i-

c i en t a t ten t i on to de t a i l, s qu ande r r e s ou r ce s i n non - bus i ne s s u s e s , and o t he r wi s e en gage

i n s e l f - s e r v i ng beh av i o r t ha t is co un t e r t o t he ob j ec t i ve s o f p r i nc ipa l s . T he gene r a l e f -

f ec t s o f s uch oppo r t un i s ti c beha v i o r a r e a d i m i nu t i on i n t he f i r m s f i nanc i a l pe r f o r m anc e

and i nc r ea s ed vu l ne r ab i l i t y t o m er ge r s , a cqu i s i ti ons , o r o t he r l o s s e s o f bus i ne s s i nde -

pend ence . A pos s i b l e s o l u t i on to t he s e m a l ad i e s i s t he c r ea t i on o f l eve r age - i nduced ,

externa l f inanc ia l obl iga t ions tha t wi l l s t imula te increased e f for t s by agent s to sa t i s fy

t he s e ob l i ga t i ons , and t hus b r i ng c l o s e r a l i gnm en t w i t h t he goa l s o f p ri nc i pa ls .

T h e f r e e c a s h f lo w c o n c e p t is m u c h m o r e g e n e r a l t h a n J e n s e n s ( 1 9 8 6 ) a p p l ic a t io n

t o co r po r a t e con t r o l and f i nance . I t app l i e s t o m any t ypes o f agency r e l a t i ons h i ps i n

wh i ch ob l i ga t i ons m ay l ead t o s t r onge r i ncen t i ve com pa t i b i l i ty be t w een p r i nc i pa l s and

agen t s. I n an ag r i cu l t u ra l s e t ti ng , t he conc ep t s ugges t s t ha t f a r m er s cou l d be i nd uced t o

exe r t g r ea t e r e f f o r t on b eha l f o f l ende r s and l and l o r ds a s t he i r ob l i ga t ions t o t he s e p r i n -

c i pa ls i nc r ea s e . A l ong t he s e l ine s , Nas r , Ba r r y , and E l l i nge r ( 1998) u t i l iz ed f a r m - l eve l

da t a t o t e s t t he f r ee ca s h f l ow hy po t hes i s and f ou nd a p os i t ive s t a t is t ic a l r e l a t ions h i p

be t w een a f a r m s t e chn i ca l e f f i c i ency and i t s r a t io o f cu r r en t deb t t o t o t a l a s se t s. T h i s

r e s u l t s ugges t s t ha t g r ea t e r r e l i ance by f a r m er s on cu r r en t deb t t o f i nance t he i r ope r a -

t i ons i s cons i s t en t wi t h t he hy po t hes i s t ha t t hey wi l l wor k ha r de r t o m ee t t he s e f i nanc i al

obl iga t ions .

4 L i q u i d i t y p r e f e r e n c e t h e o r y

A m a j o r i m p l i ca t i on o f t he p r i nc i pa l - agen t p r ob l em i n c r ed i t r e l a ti ons h i ps i s t ha t t he

p r e f e r en ces o f t he l ende r, a s exp r e s s ed by t he i n t e r e s t r a t e and n on- i n t e r e s t r a t e t e r m s

of t he l oan con t r ac t , m ay i n f l uence the r a t e o f f ir m g r owt h , r i s k m an agem en t p r ac t ic e s ,

r e s ou r ce a l l oca t i ons , and en t e r p r i s e cho i ce s o f t he bo r r ower . The i n f l uences o f i n t e r -

e s t r a t e and non- i n t e r e s t r a t e t e r m s o f loans w e r e o bs e r ve d i n ag r i cu l t u r a l f i nance by

Bak e r ( 1968) i n the 1960s and te s t ed in a num ber o f em pi r i ca l s tud i e s. Ba ke r s s t udy o f

p r i nc i pa l - agen t p r ob l em s p r eda t ed by nea r l y 10 yea r s t he landm ar k p r i nc i pa l - agen t and

agency cos t wo r k i n f inance by J ens en and M eck l i ng i n t he la t e 1970s. B ake r s app r oac h

was m o t i va t ed by l i qu i d i t y and i ncen t i ve a l i gnm en t is s ues, ho weve r , wh i l e J ens en and

M eck l i ng em phas i zed i n f o r m a t i on and i ncen t i ve i s sues .


13/59


B a k e r r e c o g n i z e d t h a t o p t i m a l r e s o u r c e a l l o c a t io n a n d e n t e r p r is e c h o i c e s o f a g r i c u l -

t u r a l b o r r o w e r s w o u l d c h a n g e t o re f l ec t l e n d e r s p r e f e r e n c e s , a s m a n i f e s t e d i n d i f fe r -

e n t ia l f i n an c i n g c o s t s . B a k e r s c o n c e p t u a l a p p r o a c h w a s t o a c k n o w l e d g e t h e t ra d i ti o n a l

p r o d u c t i o n e c o n o m i c s r e la t i o n s h ip i n w h i c h a f i r m s o p t i m a l c o m b i n a t i o n o f r e s o u r c e s is

a c h i e v e d w h e n t h e m a r g i n a l r a t e o f r e s o u r c e s u b s t it u t io n e q u a l s t h e i n v e r s e o f t h e p r i c e

r a ti o . W h e n b o r r o w i n g i s c o n s i d e r e d a s a m e a n s o f fi n a n c in g i n p u t s, t h e e c o n o m i c e q u i -

l i b r i um i s mo d i f i ed t o i nco rp o ra t e t he f i nanc ing cos t t ha t inc ludes b o th i n t e r e s t cos t s and

t h e v a l u e ( l i q u id i t y p r e m i u m ) o f b o r r o w i n g c a p a c i t y o r c r e d i t s u r r e n d e r e d i n t h e t r a n s a c -

t io n . G i v e n t h e d i s c r e p a n c y b e t w e e n t h e p r e f e r e n c e s o f t h e le n d e r a n d o f th e b o r r o w e r ,

a s re f l e c t e d b y v a r y i n g l o a n l i m i t s a n d p o t e n t i a l ly e r r o n e o u s b o r r o w e r e x p e c t a t io n s o f

l e n d e r b e h a v i o r , o p t i m a l r e s o u r c e a l l o c a t i o n c a n b e i n f lu e n c e d . T h i s i n f lu e n c e c a n t a k e

p l a c e w h e t h e r o r n o t b o r r o w i n g o c c u r s , t h r o u g h c h a n g e s i n th e s i z e a n d c o m p o s i t i o n o f

t he c r ed i t r e s e rve , g ive n it s l iqu id i t y va lu e t o t he bo r rower .

S u b s e q u e n t e m p i r i c a l w o r k f o c u s e d o n b o t h t h e l i q u i d i t y p r e m i u m c o n c e p t a n d t h e

in t e r e s t r a t e and non - in t e r e s t r a t e r e sponses o f ag r i cu l t u r a l l ende r s t o t he manage r i a l

a c t i o n s a n d b u s i n e s s c h a r a c t e r i s ti c s o f f a r m b o r r o w e r s . I n 1 9 7 1, B a r r y a n d B a k e r d e -

v e l o p e d a m o d e l i n g a p p r o a c h f o r e s t i m a t i n g t h e l e v e l s o f li q u i d it y p r e m i u m s t h a t a g ri -

c u l tu r a l b o r r o w e r s w i t h d i f f e re n t l e v e ls o f r i s k a v e r s i o n w o u l d a s s o c i a t e w i t h c r e d i t r e -

s e r v e s. R e l a t e d s t u d ie s b y V a n d e p u t t e a n d B a k e r ( 1 9 7 0 ) a n d B a k e r a n d B h a r g a v a ( 1 9 7 4 )

p r o v i d e d m o r e g e n e r a l s p e c i f i ca t io n s o f f u n c t i o n a l r e l a ti o n s h i p s b e t w e e n l i q u id i t y p r e -

m i u m s a n d s i ze s o f r e s e r v e s f o r b o t h c a s h a n d m u l t i p le s o u r c e s o f cr e d it . C h h i k a r a

( 1 9 8 6 ) t h e n s h o w e d h o w l i q u i d i t y p r e m i u m s a s s o c i a t e d w i t h c a s h a n d c r e d i t r e s e r v e s

c o u l d b e d e r i v e d f r o m t h e e x p e c t e d u t i li ty m o d e l , a n d B a r r y a n d R o b i s o n ( 1 9 8 7 ) a n d

G w i n n , B a r r y , a n d E l l in g e r ( 1 9 9 2 ) s h o w e d h o w d e b t c a p a c i t y a n d l i q u id i t y a r e re l a t e d t o

d i f f e re n t l e v e ls o f r i s k a v e r s io n , t h u s c o m b i n i n g e l e m e n t s o f e x t e r n a l a n d i n t e rn a l c r e d i t

r a t i on ing .

A c c o m p a n y i n g t h e s e s t u d ie s o f h o w a g r i cu l t u ra l p r o d u c e r s v a l u e v a r io u s s o u r c e s o f

l iq u i d it y w a s a c o m p a n i o n s e t o f s t u d ie s t h a t e v a l u a t e d t h e c r e d i t r e s p o n s e s o f l e n d e rs

t o n u m e r o u s s t ra t e g ie s i n b o r r o w i n g , d e b t m a n a g e m e n t , a n d r is k m a n a g e m e n t . I n c l u d e d

w e r e m e a s u r e s o f c r e d it r e s p o n s e s a s s o c i a t e d w i th a f a r m e r s c h o i c e o f le n d e r ; s e q u e n c e

a n d s o u r c e o f b o r r o w i n g a n d r e p a y m e n t ; f i n a n ci n g i n s t r u m e n t ; a s s e t s t ru c t u re ; e n t e r -

p r i s e m i x o f f a r m i n g o p e r a t io n s ; a n d d e g r e e s o f v e r t ic a l c o o r d in a t i o n [ B a k e r ( 1 9 6 8 );

B a k e r a n d H o p k i n ( 1 9 6 9 ) ; B a r r y a n d B a k e r ( 1 9 7 7 ) ; S o n k a e t a l . ( 1 9 8 0 ) ; B a r r y e t a l .

( 1 9 8 1 ); B a r r y e t a l. ( 1 9 9 7 )] . E m p i r i c a l m e a s u r e s w e r e d e v e l o p e d f o r l e n d e r r e s p o n s e s

to ma ny su ch s t r a t eg i e s and s i t ua t i ons . The e f f ec t s o f t he se s t r a t eg i e s and s i t ua t i ons

o n f a r m b u s in e s s p e r f o r m a n c e o f te n a r e e v a l u a te d u s in g m a t h e m a t i c a l p r o g r a m m i n g o r

s i m u l a t i o n m o d e l s i n w h i c h t h e c r e d it c o m p o n e n t s a r e b a s e d o n t h e le n d e r r e s p o n s e s .

O b s e r v a t i o n a l te c h n i q u e s u s e d i n th e s e s t u d ie s f o r e s t i m a t i n g l e n d e r s c r e d i t r e -

s p o n s e s a r e b a s e d o n s i m u l a t e d b o r r o w i n g r e q u e s ts i n w h i c h a s a m p l e o f le n d e r s r e s p o n d

t h r o u g h a s u r v e y ( m a i l , p e r s o n a l , o r w o r k s h o p - a d m i n i s t e r e d ) to c a s e l o a n r e q u e s t s f o r

r e p r e s e n t a ti v e f a r m s . T h e c a s e l o a n t y p i c a l l y in v o l v e s a f u l l y d o c u m e n t e d l o a n r e q u e s t

o v e r a n a r r a y o f p u r p o s e s a n d t e r m s , s e t h i g h e n o u g h t o a n t i c i p a t e th e l e n d e r s r e j e c t i o n

a n d d e s i g n e d f o r d e l e ti o n o f in d i v i d u a l i te m s ( u s u a l ly c a p i t a l i te m s ) u n t i l l o a n a p p r o v a l


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5 6 PJ Barry and L J Robison

i s ob t a i ned . Th e r e s u l t is an e s t i m a t e o f the f i r m s t o t a l c r ed i t, co nd i t i oned by t he pa r t ic -

u l a r s e t o f c i r cum s t anc es s u r r ound i ng the l oan r eques t . Th e ob j ec t i ve o f t he app r oac h i s

a s e t o f f unc t i ona l r e la t i ons h i ps be t wee n t he c r ed i t r e s pons es an d t he cha r ac t e r i s ti c s o f

t he l oan s i t ua t i on tha t wo u l d ho l d a s r e l i ab l e p r ed i c t o r s o f l ende r r e s pons e o ve r a wi de

r ange o f loan cond i t i ons .

Tw o exam pl e s o f the s i m u l a t ed l oan r eques t app r oach t o m eas u r i ng l ende r c r ed i t r e -

s pons es a r e s tud i e s by Ba r r y and W i l lm an n ( 1976) and P f l uege r and Ba r r y ( 1986). Ba r r y

and W i l lm an n f oc us ed on t he r e l a t ions h i p be t w een c r ed i t ava i lab i li ty and f o r w ar d con -

t r ac t i ng o f com m odi t y s a l e s by f a r m er s a s a r i s k m anagem en t t oo l . Us i ng a s i m u l a t ed

bor r ow i ng app r oach t o eva l ua t e t he r e s pons es o f a s am pl e o f l ende r s to a l te r na t ive l ev -

e l s o f f o r wa r d con t r ac t i ng by c r op f a r m er s , t hey f ou nd t ha t t he m o s t p r e f e r r ed leve l s

o f c o n t r a c ti n g g e n e r a t e d a b o u t 1 7 p e r c e n t m o r e t o t a l c r e d it a n d a b o u t 5 3 p e r c e n t m o r e

ope r a t i ng c r ed i t t han t he l e a s t p r e f e r r ed leve l s . W hen t he s e c r ed i t re s pons es we r e eva l u -

a t ed i n a m u l t i - pe r i od ri s k p r og r am m i n g m ode l , t he r i s k e f fi c i en t g r ow t h p lans i n c l uded

con t r ac t i ng due t o bo t h t he f avo r ab l e e f f ec t s on c r ed i t and t he l ower p r i ce r i s ks . The

m o de l r e s u l t s i nd i ca t ed con t r ac t i ng even f o r f a r m er s wi t h l i t tl e o r no r i s k ave r s i on , and

even t ho ugh exp ec t ed p r o f it s w e r e h i gh e r f o r t he non - con t r ac t s a le s , r e f le c t i ng the m i s -

a l i gnm en t o f incen t i ve s be t w een t he bo r r ow er and t he l ende r .

P f t u eg e r a n d B a r r y ( 1 9 8 6 ) c o n s i d e r e d h o w a s a m p l e o f n o n - r e a l- e s ta t e l e n d e rs w o u l d

r e s pon d t o a f a r m er s u s e o f c r op i n s u r ance a s a ri s k m an age m en t t oo l. The r e s u l ts o f

t he s u r vey , a ls o ba s ed on s i m u l a t ed l oan r eques t s , i nd i ca t ed a pos i t ive c r ed i t re s pon s e

by abou t 60 p e r cen t o f t he l ende r s , wi t h l it t le change s i n i n t e r e s t r a t e s and l oan m a t u -

r it ie s . A s t ochast ic , m u l t i - pe r iod s i m u l a t i on m ode l was u s ed t o eva l ua t e t he e f f ec t s o f

t he l ende r s c r ed i t r e s pons es and t he u s e o f c r op i n s u r ance o n t he f a r m s p r o fi tab i l it y ,

s o l vency , l iqu i d i ty , and s u r v ivab i li ty . The s i m u l a t i on r e s u lt s , w h i ch m ode l ed an ea r l y

1980s f a r m s i tua t i on a l r eady ex pe r i enc i ng f i nanc i al s tr e ss , i nd i ca t ed t ha t c r op i n s u r anc e

and t he c r ed i t r e s pons es i m pr oved f a r m s u r v i va l and l i qu i d i t y , bu t add i t i ona l bo r r ow-

i ng o ccu r r e d to s us ta i n t he f i r m und e r adv e r s e p r o f it cond i t i ons . Thus , r edu c t i ons i n t he

r ep r e s en t a t i ve f a r m s bus i ne s s r i s k w e r e l a r ge l y o f f s e t by i nc r ea s e s i n f i nanc i a l r i s k ( s ee

Sec t i on 7 . 2 be l ow) .

5 R e l a t i o n s h i p s i n a g r i c u l t u r a l f in a n c e

Rel a t i ons h i ps m ay i nvo l ve t wo i m po r t an t cha rac t e ri s ti c s : in f o r m a t i on and s ym pa t hy .

R e l a t i o n s h i p s m a y a r i s e f r o m c l o s e a n d c o n t i n u e d e x c h a n g e s b e t w e e n t w o e c o n o m i c

agen t s i nc l ud i ng s upp l i e r s and us e r s o f f inanc i a l c ap i ta l . S om e o f t he i n f o r m a t i on ac -

qu i r ed i n t he s e exch anges m ay i nvo l ve eco nom i c da t a re l a t ing t o ca s h f lows , deb t ob l i -

ga t ions , a s s e ts , and i nv es t m en t p l ans . Ot h e r k i nds o f da ta acq u i r ed m ay i nc l ude t he

p r e f e r ences , va l ue s , and ch a r ac t e r t ra i ts s h a r ed by t he pa r t i e s t o t he exchang e .

Fo r the m os t pa r t , f inanc i a l r e l a ti ons h i ps have been exam i ned i n t he p r e s en ce o f i n -

com pl e t e i n f o r m a t i on and agen t s m o t i va t ed by s e l f -i n t e r e s t [ Pe t e r s en and R a j an ( 1994 ,

1995) ] . Mos t r ecen t l y , t he i n f l uence o f r e l a t i ons h i ps t ha t i nc l ude bo t h i n f o r m a t i on

a n d s y m p a t h y h a s b e e n e x a m i n e d u s in g t h e n e w l y d e v e l o p e d s o c ia l c a p it a l p a r a d i g m


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Ch 10: AgriculturalFinance

527

[ Schm i d and R ob i s on ( 1995) ] . Soc i a l c ap i ta l r ep r e s en t s a d i f f e r en t app r oach t o t he

p r i nc i pa l - agen t ana l ys i s i n w h i ch s ym pa t hy r ede f i ne s ex t e rna l i ti e s .

A n e x t e rn a l i ty is c r e a t e d w h e n o n e a g e n t c r e at e s a n o u t c o m e f o r a n o t h e r a g e n t w i th -

ou t pe r m i s s i on f r om t he a f f ec t ed agen t . W hen s oc i a l c ap i t a l ex is t s, wha t o t he r wi s e m i gh t

be co ns i de r ed an ex t e r na l i t y i s i n t e r na l i z ed wi t h f avo r ab l e econo m i c ou t com es . T r ans -

ac t i ons and m on i t o r i ng cos t s a r e r educed beca us e r e l a ti ons h i ps r educ e the i ncen t i ve f o r

exp l o i t i ve beh av i o r t ha t p r od uces n ega t i ve ex t e r na li t ie s , and i nc r ea s e t he i ncen t i ve t o

m ee t con t r ac t ed ob l iga t i ons . Soc i a l c ap i ta l m ay h e l p exp l a i n wh y f am i l y bus i ne s s e s r i ch

i n s oc i a l c ap i ta l app ea r t o do m i na t e o t he r t ypes o f bus i ne s s o r gan i za t i ons . To i l lu s t ra t e ,

f a m i l y b u s in e s s es a c c o u n t f o r 7 5 p e r c e n t o f O r e g o n s s m a l l c o m p a n i e s [ N e l to n ( 1 9 9 0 )] ,

a n d 7 5 p e r c e n t o f U . S . c o m p a n i e s a r e f a m i l y - o w n e d o r c o n t r o ll e d [ C a lo n i u s ( 1 9 9 0) ].

I n ag r i cu lt u r a l f i nance , the k ey i s s ues an d r e s ea r ch i n it i at ive s have r e s p ond ed t o t he s e

ques t ions : H ow have t he m a j o r a t tr i bu te s o f r e l a ti ons h i ps changed o ve r ti m e , and ho w

do r e l a t i ons h i ps r e s po nd t o chang es i n m ar k e t com pe t i t i on? W ha t i s t he na t u r e o f t he re -

l a ti ons h i ps be t we en ag r i cu l tu r a l bo r r ower s and t he i r lende r s ? I n wha t way s do f a r m er s

i nves tm en t s , f i nanc i a l pe r f o r m ance , r i s k m ana gem en t , and o t he r bus ine s s p r ac t i c e s i n -

f l uence t he cos t , ava i l ab il it y , and o t he r t e r m s o f f i nanc i a l c ap it a l ? Ho w i s c r ed i t s co r i ng

app l i cab l e t o f i nanc i a l r e l a ti ons h i ps i n ag r i cu l tu r e? How do ag r i cu l tu r a l l ende r s m an age

c r ed i t r i s k s ? Ho w do r e l a t i ons h i ps be t w een l ende r s , bo r r ow er s , and o t he r pa r ti e s i n f lu -

ence l e a s i ng , ag r i bus i ne s s l end i ng , and o t he r bus i ne s s p r ac t i c e s ? Thes e ques t i ons a r e

addr e s s ed i n t he f o l l owi ng s ec t ions .

5 1 Re la t i onsh ip conc ep t s

Rel a t i ons h i ps dev e l op t h r ough i n t e r ac t ions be t we en pa r t i e s ove r t im e a nd / o r a c r os s m u l -

t i p l e f i nanc i a l p r oduc t s and s e r v i ce s . Re l a t i ons h i ps d i r ec t l y i nvo l ve t he gene r a t i on o f

r e l i ab l e and ac cu r a t e i n f o r m a t i on abou t t he pa r t i e s t o a f i nanc ing t r ans ac t ion , t he u s e

o f s uch i n f o r m a t i on i n eva l ua t i ng and m on i t o r i ng c r ed i t wor t h i ne s s , and t he im pac t s i n -

f o r m a t i on ha s on t he r educ t i on o f agen cy cos t s and on t he r e s o l u t i on o f adve r s e s e l ec -

t i on and m or a l haza r d p r ob l em s . Th e an t i c i pa t ed r e s u lt s o f e f f ec t i ve r e l a ti ons h i ps a r e

i m p r oved ava i l ab il it y o f f i nanc i a l c ap i ta l and r edu ced cos t s o f f i nanc ing t r ans ac t ions .

I nc r ea s e s i n com p e t i t ion , howev e r , m ay w or k aga i ns t t he bene f i ts o f re l a t ions h i ps and

resul t in less favo rable access to f inanc ia l ma rke t s fo r new er f i rms or f inanc ia l ly s t ressed

fi rms.

5 2 Evo l v ing na ture o f r e la t i onsh ips

Th e na t u r e o f r e l a ti ons h i ps ha s chan ged ove r t i m e a s f i nanc ia l m a r ke t s w e r e de r egu l a t ed ,

f i nanc i a l m a r ke t cond i t i ons becam e m or e vo l a t i l e , and f i nanc i a l i n s t i t u t i ons evo l ved

f r om p r i m ar i l y com m er c i a l banks and o t he r depo s i t o r y i n s ti t u ti ons t o b r oade r f inan -

c i al s e r v i c es c o m p a n i e s . H o d g m a n ( 1 9 6 1 ) i n t ro d u c e d t h e c u s t o m e r r e l a ti o n s h ip c o n c e p t

i n b a n k i n g b y s h o w i n g th e i m p o r t a n c e o f c u s t o m e r s d e m a n d d e p o s it s a s a s o u r c e o f

a bank s c apac i t y t o l end and i nves t, and t he r e s u l t i ng i m p or t ance o f a bank s r e l a t ion -

s h ip t o lo a n c u s t o m e r s w h o h o l d d e m a n d d e p o s i ts . W o o d ( 1 9 7 5 ) e x te n d e d H o d g m a n s


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P J Barry and LJ Robison

c u s t o m e r - d e p o s i t r e l a ti o n s h i p t o m u l t i - p e r i o d s b y s h o w i n g h o w a l ib e r a l l e n d i n g p o l i c y

may i nduce i nc r ea se s i n f u tu r e depos i t s t ha t c an , i n t u rn , be l oaned o r i nves t ed . Wood

a l s o a d d e d t h e c u s t o m e r lo a n r e l a t io n s h i p w h i c h s u g g e s t s t h a t a b a n k ' s c u r r e n t l e n d in g

po l i cy i n f l uences i t s f u tu r e l oan demands . Ba r ry (1978 ) app l i ed t he se depos i t r e l a t i on -

s h ip c o n c e p t s t o e s t i m a t e t h e r a te o f l o a n - d e p o s i t f e e d b a c k i n r u ra l b a n k i n g a t a t im e

w hen b ank s we re s t i l l sub j ec t to s t r i ngen t r egu l a t i ons on de pos i t r a te s , r anges o f p rod -

u c t s a n d s e r v ic e s , a n d g e o g r a p h i c s c o p e o f o p e r a t io n s . H i s r e s u l ts s h o w e d a r e l a t iv e l y

h i g h r a t e o f l o a n - d e p o s i t f e e d b a c k t h a t c o n t r i b u te d t o t h e b a n k ' s p r o f i t a b i li t y o f b r in g i n g

non - loca l sou rce s o f f unds i n to l oca l l end ing m arke t s .

S h a r p e ( 1 9 9 0 ) c o n s i d e r e d a s y m m e t r i c i n f o r m a t i o n a s a d e t e r m i n a n t o f c u s t o m e r

r e l a ti o n s h i p s a t t r ib u t a b le t o a b a n k ' s m o n o p o l y p o w e r o v e r i ts e s t a b li s h e d , h i g h e r -

p e r f o r m i n g b o r r o w e r s w h o b e c o m e i n f o rm a t i o n a l l y c a p t u re d b y th e b a n k . T h e a d -

v e r s e e f f ic i e n c y c o n s e q u e n c e s o f t h is i n f o r m a t i o n a l i m p e r f e c t i o n a r e r e d u c e d b y i m p l i c i t

con t r ac t s a r i s i ng f r om the i n s t i t u t i on ' s e f fo r t s to c r ea t e a r epu t a t i on a s a r e l i ab l e l ende r .

T h e t e r m s o f s u ch c o n t r a c t s d e p e n d o n t h e i n s t it u t i o n 's d e g r e e o f i n f o r m a t i o n a l a d v a n -

t a g e, r e p u t a t i o n a l p e r c e p t i o n s , a n d o t h e r d e t e r m i n a n t s o f c u s t o m e r p r o fi ta b i li ty . S h a r p e

con t r a s t s h i s ex -pos t , i n fo rma t ion -d r iv en r e l a t i onsh ip t he o ry t o an a l t e rna t i ve j u s t i f i c a -

t io n s u g g e s t e d b y W a c h t e r a n d W i l l ia m s o n ( 1 9 7 8 ), b a s e d o n t h e e x i s t e n c e o f e x -a n t e ,

r e l a t i onsh ip - spec i f i c c ap i t a l i nves tme n t c r ea t ed by t he p r e - l oa n eva lua t i on .

M o r e r e c e n t l y , P e t e r s e n a n d R a j a h ( 1 9 9 4 , 1 9 9 5) c o n s i d e r e d t h e i n t er a c t io n s b e t w e e n

l e n d e rs , b o r r o w e r s , a n d f i n an c i a l m a r k e t p e r f o r m a n c e . T h e i r 1 9 94 a r t ic l e u s e s d a t a f r o m

a n a t i o n a l s u r v e y o f s m a l l , n o n - f a r m b u s i n e s s e s t o d e t e r m i n e t h a t i n f o r m a t i o n - b a s e d

re l a t i onsh ips m ay h ave s i gn i fi c an t , pos i t i ve e f f ec t s on c r ed i t ava i l ab i l it y , and l e s s s i gn i f -

i c an t r educ t i ons i n c r ed i t co s ts . The i r 1995 a r t i c le u se s t he s am e da t abase t o t e s t t he in -

t e r a c ti o n s b e t w e e n l e n d i n g c o m p e t i t i o n a n d t h e a v a i l a b i l it y a n d c o s t o f c r e d i t f o r y o u n g

o r f i n an c i a ll y s t r e ss e d b o r r o w e r s , b o t h o f w h o m w e r e f o u n d t o b e n e f i t f r o m s t r o n g e r re -

l a ti o n s h i p s in m o r e c o n c e n t r a t e d m a r k e t s . L e s s c o m p e t i t iv e m a r k e t s m a y b e t t e r e n a b l e

l ende r s t o g r an t sho r t - run conc es s ions t o d i s adv an t ag ed f irms , wh i l e ad ju s t i ng f i nanc ing

t e r m s i n m o r e f a v o r a b l e t i m e s t o s h a r e i n t h e f u t u r e s u r p l us o f t h e b o r r o w i n g f ir m .

B a r r y , E ll in g e r , a n d M o s s ( 1 9 9 7 ) a p p l i e d t h e P e t e r se n a n d R a j a n c o n c e p t s t o e v a l u a t e

t h e i n f l ue n c e o f t h e c o m p e t i t iv e n e s s o f a g r i c u lt u r a l l en d i n g m a r k e t s o n l e n d e r - b o r r o w e r

r e la t i o n sh i p s . T h e i r f i n d in g s c l e a r l y i n d i c a te a n i n v e r s e r e l a ti o n s h i p b e t w e e n c o m p e t i -

t io n a n d b o r r o w e r l o ya l ty , w h i c h s e r v e s a s a p r o x y f o r t h e l e n d e r - b o r r o w e r re l a ti o n s h ip .

B a n k e r s i n m o r e c o m p e t i t i v e f a r m r e a l e s t a te a n d n o n - r e a l - e s t a te l e n d in g m a r k e t s t e n d

to have l e s s l oya l cus tomer s , i r r e spec t i ve o f o the r i n s t i t u t i ona l and marke t cha r ac t e r i s -

t i c s . None the l e s s , ev idence [Ba r ry and E l l i nge r ( 1997 ) ] s t i l l sugges t s t ha t r u r a l f i nan -

c i a l m a r k e t s a r e m o r e c o n c e n t r a t e d a n d l e s s c o m p e t i t i v e t h a n t h e ir u r b a n c o u n t e r p a rt s .

A g r i c u l t u r a l a n d r u r a l b u s i n e ss l e n d in g , t h us , r e p r e s e n t s n i c h e m a r k e t s f o r m a n y l o c a l

l ende r s i n wh ich spec i a l i z a t i on i s conduc ive t o r e l a t i onsh ip -bu i l d ing , t a rge t ed sk i l l s i n

f i nanc i a l ana ly s i s , and t he t ypes o f i n fo rma t iona l advan t ages c i t ed by Sha rpe (1990 ) .

T u r v e y a n d W e e r s i n k ( 1 9 9 7 ) e x t e n d t h e a n a l y s i s o f th e l e n d e r - b o r r o w e r re l a t io n s h i p

t o p r o v i d e e m p i r i c a l e v i d e n c e a b o u t l o a n d e m a n d / c o n t r a c t c u r v e s f o r a g r ic u l tu r a l l o a n s .

U s i n g e x p l i c it li n k a g e s t o c r e d i t - s c o ri n g m o d e l s i n e s t i m a t i n g l o a n d e m a n d p a r a m e t e r s ,


17/59

Ch 10: AgriculturalFinance 529

t hey f i nd ev i dence o f backwar d - bend i ng l oan dem and cu r ves , r e f l e c t i ng t he p r ope r t i e s

o f a s ym m e t r i c i ncen t ive s and i n f o r m a t i on in ag r i cu lt u r a l l end i ng . Th es e r e s u l ts , i n t u r n ,

s ugges t s om e d eg r ee o f c r ed i t r a t i on i ng i n ag r i cu l t u r a l l end i ng .

5 3 Credit evaluation procedures

Pr ev i ou s s tud i e s o f c r ed i t re l a t ions h i ps i n ag r i cu l t u r e have s how n t ha t the r e s pons es o f

l ende r s t o t he bus i ne s s cha r ac t e r i s t i c s , m anage r i a l a c t i ons , and o t he r agency cos t s o f

f inanc ing agr icul tura l f i rms inf luence the cos t , ava i l ab i l i ty , and o ther t e rms of f inanc ia l

cap i ta l , i nc l ud i ng t he m agn i t ude and com pos i t i on o f l i qu i d c r ed i t r e s e r ves ( s ee t he s ec -

t i on on l i qu i d i ty p r e f e r enc e , Sec t i on 4 o f t h is ch ap t e r ). I n t u r n , t he s e cos t e f f ec t s m ay

i n f l uence t he op t i m a l f i nanc i a l s t ruc t u r e ( l eve rage ) and f i nanc i a l pe r f o r m a nce o f f a r m

bus i nes s e s a s w e l l a s t he com pos i t i on o f t he i r a ss e ts , r i s k m an agem en t p r ac t ic e s , and

o t he r i ncom e- gene r a t i ng ac ti v it ie s . Th es e s t ud i e s do no t , howev e r , d i rec t l y cons i de r t he

ag r i cu l tu r a l l ende r s p r o ces s e s o f c r ed i t eva l ua t ion , i nc l ud i ng t he r e l a t ive i m po r t ance o f

t he m a j o r v a r i ab le s a f f ec t i ng c r ed i two r t h i ne s s .

I n con t r a s t, a g r ow i ng s e t o f s t ud ie s ( e .g . , Lu f bu r r o w e t a l. ( 1984) ; Du nn and F r ey

( 1976) ; H a r dy and W eed ( 1980) ; F i s che r and M oo r e ( 1987) ; S t ove r e t al. ( 1985) ; Mi l l e r

a n d L a D u e ( 1 9 8 9 ); T u r v e y ( 1 9 9 1 ) ; T u r v e y a n d B r o w n ( 1 9 9 0 ); M i l l e r e t a l. ( 1 9 9 4 ) ; N o -

vak and L aD ue ( 1994) ; Chh i ka r a ( 1989) ; Sp l e t t e t al. ( 1994) ; and Ag u i l e r a - Al f r ed and

Gonza l ez - Vega ( 1993) ] have f ocus ed on t he c r ed i t eva l ua t i on p r oces s , i nc l ud i ng t he

dev e l opm en t and va l i da t i on o f va r ious t ypes o f c r ed i t- s co r i ng m o de l s , and on p r ed i c t -

i ng f i nanc i a l s t re s s and bankr u p t cy p r ob l em s o f f a r m er s [ Shep a r d and Co l l i n s ( 1982) ;

F r anks ( 1998) ] . Ag r i cu l tu r a l l ende r s t hem s e l ve s have acce l e r a t ed t he deve l op m en t and

us e o f m or e f o r m a l m e t hod s o f c r ed i t eva l ua t ion [ M i l le r e t al. ( 1993 ) ] , i n l i gh t o f g r ow-

i ng c once r ns abo u t l oan qua l i t y , inc r ea s ed c om pe t i t i on i n ag r i cu l tu r a l l end i ng , e f f o r t s t o

con t r o l l end i ng cos t s , and i m pr o vem en t s in da t a qua l i t y and l oan i n f o r m a t i on s ys t em s .

Th es e

2. Agricultural Finance(1)

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