Generally, banks lending to agriculture didn't participate aggressively in the high-risk housing or commercial real estate markets like the banks that felt the biggest impact from the financial crisis, says University of Illinois economist Paul Ellinger, and that has helped them continue to improve their overall financial health.
But there's still costs to be incurred – ones from which the ag lenders are continuing to recover.
Several new hurdles, for example, have appeared in the long wake of the financial crisis. New bank regulations have resulted in increased lending standards, reduced investments in exotic derivatives, higher capital positions across the commercial banking landscape, and regulatory compliance costs.
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"Typically, as a share of total operating costs, these compliance costs are greater for smaller banks," Ellinger writes in a recent FarmDoc Daily post. "There is continued pressure to merge institutions and gain potential cost economies and synergies."
Ag lenders, however, have enjoyed the profitability of agriculture within the past decade, which has helped mitigate their nonfarm real estate losses.
Although agricultural loans at commercial banks have increased 30% from 2007 to 2013, overall loan balances relative to bank deposits are at the lowest level in the banking sector in 30 years. The declines are a signal of weak loan and economic growth in the country, Ellinger explains.
After the crisis, regulators and policy makers have focused on the capital levels of commercial banks. The capital level of a bank is one of the strongest indicators of the financial health of the institution. Higher levels of bank capital signal a higher buffer for unexpected loan losses and declines in values of assets.
A commonly used measure is the tier 1 risk-based capital measure. It is the ratio of the "core capital" relative to its risk-weighted assets. Each bank asset is assigned a risk category and an associated risk weight. For example, cash at a bank has a lower risk weight than loans.
Among other factors, bank regulators consider a bank well-capitalized when this ratio exceeds 6%, adequately capitalized when it is 4% or more, undercapitalized below 3%, and critically undercapitalized at 2% or below.
The average tier 1 risk-based ratio increased from 15.8% in 2007 to 16.9% by year end 2013 for banks lending to agriculture. Banks have been increasing their tier 1 capital ratios since the crisis and are at levels that exceed regulatory requirements, Ellinger explains.
More than 96% of the banks that lend to agriculture have tier 1 capital ratios that exceeded 10% at year-end 2013. The major improvements in capital levels have been at the larger institutions.
Tighter profit margins for producers, however, combined with volatile commodity prices increase the risks faced by borrowers. Moreover, interest rate risk may increase in the next 18 months – and banks will need to continue to implement prudent risk-management strategies, monitor economic conditions, and explore new opportunities to enhance competitiveness and viability.
So while there will continue to be new challenges and headwinds, new regulations and compliance costs, the financial health and profitability of commercial banks lending to agriculture continues to improve.
The strong financial health of the sector provides a solid base. The commercial banking sector is in a strong position to meet the capital needs of agricultural borrowers, Ellinger says.
Read the full report on the University of Illinois Farmdoc site.