Default Risk in Agricultural Lending: The Effects of Commodity Price Volatility and Climate

This paper proposes and estimates a default risk model for agricultural lenders that explicitly accounts for two risks that are endemic to agricultural activities: commodity price volatility and climate. The results from the study indicate that both factors are relevant in explaining the occurrence of default in the portfolio of a rural bank. In addition, the paper illustrates how to integrate the default risk model into standard techniques of portfolio credit risk modeling. This method provides a quantitative tool to estimate the loss distribution and the economic capital for a rural bank. The estimated parameters of the model, along with scenarios for the evolution of the risk factors are then used to conduct stress tests on the portfolio of a rural bank. Through the stress tests, the paper finds that climate factors have a larger effect on economic capital than commodity price volatility. The paper covers the following sections in detail:

• Introduction to risk management in agriculture and review of relevant literature;
• Risk factors in agricultural projects;
• Discussion on the structural credit risk model used for the study;
• Portfolio credit risk model for a rural bank;
• Stress tests, baseline results, and a summary of findings.