Module 1: Risk Management in Agricultural Finance

Developed by: Rene Verberk, Yifredew

Bizualem

Lesson 1.4: Position of the bank, risk management and monitoring

Learning Objectives

By the end of this lesson, participants will be able to:

• enumerate important aspects of risk management;

• explain why monitoring is important;

• describe specific characteristics of monitoring for agribusiness;

• detect early warning signals;

• list the types of collateral that exist.

Lesson 1.4 Position of the bank, risk management and monitoring

Table of Contents
1. Risk Management 4

1.1 Credit Base 4

1.2 Structure Risk 4

2. Monitoring 5

2.1 Credit risk monitoring 5

2.2 Plausibility check 5

2.3 Signal driven monitoring 6

2.4 Portfolio monitoring 6

2.5 Early Warning Signals 6

3. Collateral 7

3.1 Collateral as loan security 8

3.2 Non-financial Covenants 8

4. Summary 1
1
5. Additional literature 1
1

List of the main acronyms used in the text

SME Small and Medium Enterprises

MACC Material Adverse Change Clause

Photo on front page: ©FAO

Please note that this material is intended for private educational use by participants in the
agricultural and rural finance training jointly organized by ADA (http://ada-microfinance.org/)
and FAO (http://www.fao.org/) through the CABFIN project. Each document is the property
of its author, and may be protected by copyright and/or intellectual property laws. Any
unauthorized use of this material would violate these rights; therefore, before using this material
for any purpose, please contact the author or publisher for written permission, in accordance
with national and international laws and conventions protecting intellectual property.

Lesson 1.4 Position of the bank, risk management and monitoring

Introduction

In this module we will focus on the position of the bank, one of the pillars of the three- pillar
model. We will discuss the importance of risk management before disbursement, and risk
management after disbursement, as well as the monitoring process.
The more knowledge the financial institution has of an Agri sector, the better it understands the
sector and the better equipped it is to organize the risk management process.

We will discuss the importance, but also the limitations, of a strong collateral. Position

of the bank

Conclusion / Recommendations

Figure 1: Position of the bank as part of the three-pillar approach

It is essential to approach a (new) financing request in terms of "sources of
repayment". When taking this approach one can assign a logical and preferred order
of these sources:
The first source of repayment is cash flow; the cash generated out of the normal
course of business e.g., the income out of sales of products minus all the cost in a
certain period needs to show a positive cash flow.

Lesson 1.4 Position of the bank, risk management and monitoring

The second source of repayment are other forms of collateral items; for example, guarantees by
the government/funds/banks or individuals. In case of losses, these guarantors will bear part of
the losses and therefore reduce the risks for the bank.

The last source of repayment, when the other two do not cover all the losses, is collateral or
security; if the other 2 sources are not sufficient to repay your loan, collateral should be
executed. For example, by (legally) taking over the pledged or assigned stocks and sell them
on the market yourself, or even by selling the client's property.

1. Risk Management

1.1 Credit Base

When assessing an application, we should know exactly who (one or more persons
individually) or which entity (within a group of companies or in a cooperative) we are
lending to: who is our direct legal counterparty. Or, in other words, the party or parties
to whom we have legal recourse on first demand, or conditionally, to seek repayment
from.

The credit base refers to all the parties that need to stay in good financial health during
the life of the loan or credit facility. Examples are guarantors, contract parties, major
suppliers and off-takers, shareholders, other group entities.

Once this has been determined, you should check whether there is structural
subordination (worse off as lender). Or, in a better scenario whether, as a lender, we
are structurally senior (in a better position).

1.2 Structure Risk

Structure risk is the risk that the bank will be prevented from accessing cash flows or
assets because of:

• The company's group structure: is the bank granting a loan to a holding

company or operating company where all the cash flow (our first source of
repayment) is generated? Are there intercompany loans? Are there
dividends payments to shareholders or owner?
• Debt priority: are other banks also financing? What are their financing
conditions?
• Financing terms: Tenors/Linear amortizing repayment or balloon/bullet?
/Repayments starting earlier?

If you are confronted with structure risks, it should be clear whether sufficient
mitigations are in place. Normally, a bank will impose certain conditions to reduce
these risks and protect the position of the bank if things turn bad.

Lesson 1.4 Position of the bank, risk management and monitoring

Risk mitigations for structure risks are:

• Guarantees: from persons individually, from companies, from banks, from

governments.
• Restrictions: for example, you set conditions for, or do not allow, cash to flow
from your legal counterparty or parties, otherwise it will hurt your first source of
repayment (CASH)
• Transfer pricing: you set the condition that intercompany transactions should
be calculated according to market conditions ("at arm's length").

2. Monitoring

2.1 Credit risk monitoring

The account manager is responsible for the daily monitoring and maintains regular
contact with the client. Depending on the size and financial standing of the client,
reviews of the credit, collateral and conditions will be performed periodically. Credit
risk management stands and falls on the timely reporting of business figures by the
client. Any contract will become meaningless if the information to assess the
development is delivered late or not at all. If a client is not willing or prepared to share
financial figures, it is legitimate to ask how they manage their company. Experience
tells us that every company has some (specific) indicators, alongside the financial
figures, which are important to the company.

The basis of credit risk monitoring is the monitoring plan which should be drawn up
with the customer wherein review moments are agreed upon.

2.2 Plausibility check

Two very good methods to test the reliability of financial or commercial information
are the 'double checking' of data and the performing a 'plausibility check'.
Whatever the source of information, errors can be made, and during a loan analysis
one should always ask does this information make sense, is it in line with other market
data? The good loan officer will learn how to detect strange things in the figures. It
might be possible that they have made an error themselves or maybe the customer
has made a mistake; but that does not matter as long as it is detected in time.

Once a loan has been disbursed, adequate monitoring must ensure that the loan
stipulations are followed over time and that the financial soundness of the financed
company does not show an unfavorable development. A monitoring plan,
comprising the loan stipulations that must be controlled, must be drawn up and
followed.

A periodic (monthly, quarterly, semi-annually) compliance check on adherence to

(financial) covenants must be made. Breaches of covenants must be reported to the
Credit Committee to obtain a waiver, extension, restructuring approval or other
action.

Lesson 1.4 Position of the bank, risk management and monitoring

2.3 Signal driven monitoring
The daily monitoring of facilities below a particular amount is not based on reviews
and call reports, but is based on system generated signals, such as unusual payments
or changes in payment behavior, margin calls etc., which are reported immediately.

2.4 Portfolio monitoring

In addition to the individual monitoring, the implementation of a monitoring system at
portfolio level is highly recommended, because agri-business financing has a cyclical
nature.
The economic situation and potential of the branch of industry must be assessed.
Sources for macro- economic and branch of industry information are statistical
bureaus, ministry of agriculture at state and regional level, agricultural organizations
and agri-business companies.

2.5 Early Warning Signals

Special attention should be given to early warning signals. Before formal reporting,
points of attention can be detected that could at a later stage lead to problems and
emerging real problems often cast their shadow beforehand.
Early warning signals are:
• Too many new activities in the company
• Deviations from loan conditions: use of credit for goals other than the original
purpose of the loan is a risk factor. This risk can be mitigated by loan
conditions that follow the cash flow pattern of the company.
• Late payment of instalments or interest.
• Deterioration of collateral: insufficient maintenance of collateral decreases
the value of the pledged assets, and also signals insufficient cash or
management that is not 'on top of the job'.
• Negative press-coverage: usually there is no reason for panic, but it must be
researched immediately to determine if negative publicity, e.g., on layoffs,
quality problems, loss of a big contract, is gossip or points to emerging
problems.
• Current account pattern: the pattern of transactions and balances on the
current account or use of a credit facility, are an excellent way of looking at
a client. Therefore, the bank must encourage customers to use the current
account for payment transactions. For disbursement of loans this should be
standard, and this also applies to using a bank account at the same bank
where a loan is obtained. For a credit facility in current account this is inherent
to the bank service itself.
Other Early Warning Signals are:
• Legal problems
• Crop or animal diseases
• Quality problems
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Lesson 1.4 Position of the bank, risk management and monitoring

 • Disconnected phone
• Request for release of collateral
Current Account and Credit Facility in current account
As far as is possible, bigger loan clients in particular should be encouraged to use a
current account held at the bank from which the loan has been obtained to carry
out their external financial transactions. A current account is a bank account of a
business customer which is used to pay creditors by giving the bank an instruction to
transfer money to the bank account of the creditor. Traders deposit cash into their
account at the end of the day so the money is kept safely in the bank vault.
Limit breaches or the constant maximum use of the credit facility are an early warning
signal of emerging problems. When the balance of the account is stable at a low
level, this can mean that the customer is possibly doing business with another bank,
which is a warning signal for account management that the relationship is threatened.
Therefore, the bank must encourage customers to use the current account for
payment transactions. For the disbursement of big loans, the use of a current account
should be a standard procedure, as well as using a bank account at the same bank
where the loan is obtained. For a credit facility in current account, the customer is, of
course, required to have a current account.

3. Collateral
Repayment capacity from ongoing business operations must represent the primary
source of repayment for each loan transaction and relationship. Even though
collateral liquidation is generally only an alternative source of repayment, analysis of
this source is important in determining a sound credit package.
Collateral can be segregated by the following general categories which are
presented in the order of liquidity:
Current assets: this category includes all items that a customer would typically convert
to cash in less than one year in the ordinary course of business. These security items
might include marketable securities, accounts receivable, inventories, livestock.
Machinery and Equipment: these security items can include farm related machinery
and equipment, manufacturing and processing equipment.
Real Estate: this category includes agricultural land and facilities. These collateral
items are generally slowly depreciable and provide stable security for long-term loans,
but the market value of the collateral may be affected by cyclical economic
conditions.
Guarantees: in addition to these categories, guarantees provide collateral value as
alternative source of repayment.
Collateral liquidity, or the expected time and transaction cost to convert an asset
pledged as security to cash, is an important consideration in properly securing loans.

Lesson 1.4 Position of the bank, risk management and monitoring

It is normal to ask SME companies for collateral. Depending on the importance of the
client and the risk appetite of the bank, it could be decided not to ask for collateral,
although this is not the preferred way to do business with SME companies. You should
also be very careful about the amount of the loan or the credit facility; do not lend
too much if the client does not have a specific and viable usage for it.

3.1 Collateral as loan security

Generally, more liquid assets (inventories, receivables) are aligned with short maturity
loans. Longer term assets like machinery, equipment and real estate secure long-term
loans.
It also should be crystal clear which facility is covered by which collateral. The
collateral should be valued, where possible, with the assistance of an external
appraisal agency. For long term credit arrangements, the appraisal of the collateral
should be reviewed from time to time. The collateral should be liquid in nature, which
means that it could be sold easily on the market if necessary.
In case of the worsening creditworthiness of the client, it will probably not be possible
to fully recover the loan outstanding by selling the collateral. Therefore, safety margins
are maintained. Banks calculate with the lowest value, which is the liquidation value,
because in times of distress the value of collateral is considerably less certain than in
an on-going concern situation. Moreover, the liquidation of collateral can be a
lengthy procedure.
Therefore, in modern banking collateral is considered as less important than cash flow
(Cash is King').
Mortgages and pledges are well known forms of collateral. With mortgages, the fixed
assets are the collateral for a loan, when the current assets form the collateral, we
speak of pledges. Other forms of loan security are guarantees and insurance
(damage, life, credit).

3.2 Non-financial Covenants

Covenants are agreements between bank and customer regarding essential non-
financial events. Those so-called non-financial covenants function as early indicators
of possible problems of the debtor and can offer additional security to the bank. In
general, covenants are only applied to corporate clients and large loans. Common
covenants (for explanations see next page) are:
• Pari-Passu statement
• Cross-default
• No-change-of-ownership/management clause
• Material-adverse-change-clause
• Non-dividend clause.
Please note that the use of (non-)financial covenants and loan security conditions
should not become something that is done automatically. The client must still be able
to do business and all conditions have to be monitored, which also entails a cost. In

Lesson 1.4 Position of the bank, risk management and monitoring

the credit analysis, it is necessary to assess what reasonable combination of conditions
can balance the interests of the bank and of the customer.
Pari-Passu statement:
By signing a Pari-Passu statement, a debtor declares that they, as well as their
subsidiaries or majority participations:
• will not give collateral securities to other parties (either financers or creditors)
without written consent of the bank;
• will, if the debtor does give collateral to third parties, grant the bank equal
collateral.

Signing the statement will, amongst other things, result in a remaining equal position
of the bank against other creditors.
However, the statement does not prevent:
• other creditors being subject to tighter conditions;
• an accelerated pay off of other creditors;
• those other creditors from making a claim before the bank (this should be
covered by a cross default statement).
Even if no other financing parties are involved, it is advisable to sign a Pari-Passu
statement. The debtor may do business with other financing parties in the future and
provide them with collateral. Based on a Pari-Passu statement, this will be allowed if
the bank has given written approval and will be granted an equal collateral security.
Cross-default:
A cross default statement will ensure that if the debtor and/or any of their subsidiaries
and/or majority participations are in default of their obligations to the bank or any
other third-party creditor, the bank may rightfully re-claim the loan.
A cross default statement ensures that the bank and other creditors can instantly
reclaim their money on an equal basis, without formal notice.
No-change-of-ownership/management clause:
The quality and continuity of management is an important precondition for contract
finance. A material change in management/ownership can be a reason for a bank
to terminate an existing loan. A no-change-of ownership/management clause
ensures the bank can terminate the loan and reclaim its money if substantial changes
in ownership of the debtor, its subsidiaries or majority participations take place.
Material-Adverse-Change Clause (MACC):
This is applicable if circumstances arise that cause the bank to question the debtor's
ability to fulfil its obligations towards the bank, which can lead the bank to revise or
even terminate the money lent. A material-adverse-change clause empowers the
bank in this respect. A material-adverse-clause is very useful in case of distortions, such

Lesson 1.4 Position of the bank, risk management and monitoring

as the crisis related to foot and mouth disease, or other substantial distortions in the economical
or technical environment.

Non-dividend declaration:
By signing a non-dividend statement, the debtor ensures that no dividend will be paid
to its shareholders as long as it still owes money to the bank. If the debtor fails to
comply with this statement, the bank is entitled to revise the terms of the agreement
or even terminate it. This statement is designed to prevent a depreciation of a firm's
assets.
If the non-dividend statement is combined with a statement concerning the solvency
ratio, one should assess the situation with caution. A solvency ratio will normally be the
leading statement, since in this instance the bank may, irrespective of the cause,
terminate the agreement if the ratio is not met. On the other hand, as long as a
company meets its solvency ratios it should not be too much of a problem to pay
dividends to the shareholders. Dividend payments can also be reduced by applying
a debt-service ratio.
Information requirements vis-a-vis the bank
Several aspects should be taken into account if the bank and the client agree on
financial or non-financial ratios, these include:
• The agreed statements should fit within the specific situation and should not
be included needlessly;
• A determination of the levels at which the ratios will be set (benchmarking
against other branches may help in this case), and which ratios are currently
being met;
• A review of whether sufficient margin is kept for the envisaged ratios so that
the targeted ratios can, indeed, be met by the client.
• The bank should always review whether the client can still be financed after
determining the level at which the ratios have been set;
• Check whether the client is able to meet the high standards of information
that must be provided;
• Check whether the time and costs incurred by the bank for managing the
agreement is in line with the risk profile of the client.
It is also important that the customer understands the sometime complicated loan. In
the first place, this encourages compliance with the conditions. In the second place,
when the customer is not aware of the conditions they have signed up to, this might
have legal repercussions at a later stage.

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Lesson 1.4 Position of the bank, risk management and monitoring

4. Summary

• In this lesson we have seen that collateral is an important insurance for a bank
to prevent losses from non-repayment, although cash flow remains the main
source for paying installments and interest.

• Before disbursement of the loan, the bank should structure its collateral very well and,
following disbursement, a very disciplined monitoring of the loan will significantly
reduce the risks of non-repayment.

• For the financial institute it is important to clearly communicate the structure of the
loan, the repayment structure and other requirements. The financial institute should,
preferably, put all the requirements in the loan contract.

5. Additional literature

Guidelines on loan origination and monitoring:

https://www.eba.europa.eu/regulation-and-policy/credit-risk/guidelines-on-loan-
origination-and-monitoring

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Lesson 1.4 Position of the bank, risk management and monitoring