Rural and Agricultural Finance: FAQs

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

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.

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.

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.

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.