The Basel accords, capital reserves, and agricultural lending

The safety and soundness of financial institutions has become a leading worldwide issue because of the recent global financial crisis. Historically, financial crises have occurred approximately every 20 years. The worst financial crisis in the last 75 years occurred in 2008–2009. US regulatory efforts with respect to capital reserve requirements are likely to have several unintended consequences for the agricultural lending sector—especially for smaller, less-diversified (and often, rural agricultural) lenders. The paper discusses these issues.

Simulation models and value-at-risk (VaR) criteria are used to evaluate the impact of capital reserve requirements on lending return on equity. In addition, simulations are used to calculate the effects of loan numbers and portfolio diversification on capital reserve requirements.

This paper illustrates that increasing capital reserve requirements reduces lending return on equity. Furthermore, increases in the number of loans and portfolio diversification reduce capital reserve requirements.

The simulation methods are a simplification of complex lending practices and VaR calculations. Lenders use these and other procedures for managing capital reserves than those modeled in this paper.

Smaller lending institutions will be pressured to increase loan sector diversification. In addition, traditional agricultural lenders will likely be under increased pressure to diversify portfolios. Because agricultural loan losses have relatively low correlations with other sectors, traditional agricultural lenders can expect increased competition for agricultural loans from non-traditional agricultural lenders.

This paper is novel in that the authors illustrate how lender capital requirements change in response to loan payment correlations both within and across lending sectors.