A credit risk model for agricultural loan portfolios under the new Basel Capital Accord

The New Basel Capital Accord (Basel II) provides added emphasis to the development of portfolio credit risk models. An important regulatory change in Basel II is the differentiated treatment in measuring capital requirements for the corporate exposures and retail exposures. Basel II allows agricultural loans to be categorized and treated as the retail exposures. However, portfolio credit risk model for agricultural loans is still in their infancy. Most portfolio credit risk models being used have been developed for corporate exposures, and are not generally applicable to agricultural loan portfolio. The objective of this study is to develop a credit risk model for agricultural loan portfolios. The model developed in this study reflects characteristics of the agricultural sector, loans and borrowers and designed to be consistent with Basel II, including consideration given to forecasting accuracy and model applicability. This study conceptualizes a theory of loan default for farm borrowers. A theoretical model is developed based on the default theory with several assumptions to simplify the model. An annual default model is specified using FDIC state level data over the 1985 to 2003. Five state models covering Iowa, Illinois, Indiana, Kansas, and Nebraska areestimated as a logistic function. Explanatory variables for the model are a three-year moving average of net cash income per acre from crops, net cash income per cwt from livestock, government payments per acre, the unemployment rate, and a trend. Net cash income generated by state reflects the five major commodities: corn, soybeans, wheat, fed cattle, and hogs. A simulation model is developed to generate the stochastic default rates by state over the 2004 to 2007 period, providing the probability of default and the loan loss distribution in a pro forma context that facilitates proactive decision making. The model also generates expected loan loss, VaR, and capital requirements. This study suggests two key conclusions helpful to future credit risk modeling efforts for agricultural loan portfolios: (1) net cash income is a significant leading indicator to default, and (2) the credit risk model should be segmented by commodity and geographical location.