Warehouse financing and bank risk aversion

An earlier comment piece on ongoing tomato crisis in this space noted how “just two months ago, tomato farmers in Qila Saifullah, Balochistan took to the roads and wasted hundreds of kilograms of the produce”, an oft-heard scourge during post-harvest season when prices crash, especially for perishable commodities.

That the absence of proper storage facilities has proven to be the Achilles’s heel of Pakistan’s agriculture is rarely disagreed with, but less commonly understood. Of course, warehouses do exist as it is hard to imagine that entire commodity supply could be processed immediately post-harvest. The missing piece of the agri-value chain, however, is existence of an intermediary warehousing service, independent of both producer and buyer.

If growers could store their inventory, the problem would not exist in the first place. But because domestic farming predominantly consists of small- and subsistence lands no greater than 5-10 acres on average, growers end up resorting to distressed sales, in order to free land up for subsequent crop sowing.

Barring sugarcane – for most easily storable grains the immediate buyer is arth or the middleman, the investor who capitalizes on farmers’ predicament and procures the commodity, often at a steep discount especially against immediate cash payment. First-stage mills/processing units – especially ginneries and flour mills – are also cash-strapped small-scale operations lacking the adequate liquidity to procure commodity directly from growers. Thus, arths are known to finance mill operations as well, advancing stock/grains on credit.

It is in this context that the need for an intermediary warehousing service is most strongly felt. Facing the prospect of post-harvest losses or distressed sale to arth at a steep discount, small-scale growers are caught between the devil and the deep blue sea. The premise for an intermediary warehouse is to protect the growers from both, by offering growers facility to store commodity upon rented premises and enter delayed sale contracts when the price is right.

Except, growers also need immediate liquidity upon harvest to invest in farming inputs for subsequent crop sowing. This is where SBP’s latest framework of warehouse financing enters the fray. This, according to a notification last month will allow “banks to accept Electronic Warehouse Receipts as collateral for lending against storage of agriculture produce and commodities”.

To be fair, there is little new about financing against commodity pledge for commercial banks. Pledge finance facility has long been available to commercial and corporate borrowers, and especially common in the case of cotton. In practice, this six-month long seasonal working capital finance facility requires that the pledge be stored, usually at a third-party premise with tenancy agreement made in favour of the bank. Finance is disbursed upon pledge of commodity – of course net of margin – and commodity is later released in favour of obligor upon equivalent payment.

So how is the latest amendment to Prudential Regulations any different? Primarily, because the facility has now been extended from corporate/commercial borrowers to include agriculture finance, which thus far relied on land as primary collateral – an asset with cumbersome recourse. This is certainly a welcome development but certain caveats bear mentioning.

One, in contrast to pledge finance which is normally extended to buyer, the target market of warehouse receipt financing (WHRF) consists of growers. Because the primary repayment recourse for WHRF is the collateral itself, bank will be in the right to demand immediate partial payment upon sale (equivalent to the value of the produce drawn).

This will impede farmers’ ability to make sale on credit and may once again put them in a situation where they must take a steep discount for demanding cash payment from the buyer. Never mind the incidental costs of collateral insurance, rental expense, and of course, interest payment against the loan.

Furthermore, while availability of collateral financing to small growers is a big leap forward, its success is hinged upon commercial bank’s risk appetite. Even in pledge financing to corporate clients, banks demanding additional security – often in the shape of mortgage on land – is no rarity.

Commercial banks are able to do so because they are free to set their own agriculture financing policy as part of overall credit policy, allowing them to structurally skew internal rules and risk mitigation standards in favour of safer avenues of lending. Because violation of internal credit policy – over and above SBP’s prudential regulations - is also liable to penalty as part of audit by central banks, banks can claim ‘prudence through compliance’ even when agricultural-loan disbursements targets go unmet, due to excessive risk aversion.

This is not to insist that the SBP should dictate banks’ credit policies and appropriate risk appetite level, as these should reflect board policies in line with the objective of protecting the depositors. Nonetheless, it should be conceded that commercial banks’ risk averse behaviour is a systemic bottleneck in the broadening of lending services, especially to rural customer base. Whether the latest change to rulebook will overcome the slow-brewing crisis of low risk appetite, only time will tell.