Agricultural borrowers continue to see pressure from depressed commodity prices, and while farm incomes have stabilized in recent years, they remain well below the averages of the last decade with farmers struggling to continue their operations.
With prolonged headwinds facing the agricultural economy, the FDIC recently released a Financial Institution Letter (FIL) titled “Prudent Management of Agricultural Lending During Economic Cycles.”
This isn’t the first time the FDIC has issued guidance on agricultural lending; in fact, this Financial Institution Letter replaces and rescinds FIL-39-2014, Prudent Management of Agricultural Credits Through Economic Cycles, dated July 16, 2014. I would suggest this FIL will set regulatory expectations for agricultural lending over the next 12 - 24 month examination cycle.
With that in mind, we believe bankers should pay close attention to the following excerpts from the FDIC guidance. Here are a few reasons why:
- A structured, developed, long-term approach.
“…cash flow margins for agricultural borrowers have become increasingly pressured by changes in supply and demand factors, poor weather conditions, and agricultural policy factors. Row crop operating expenses have risen while soybean, corn, and wheat prices have fallen. Livestock sectors have also been challenged, especially dairy farming and cattle feeding. Farm working capital levels have deteriorated, debt balances have increased, and debt repayment capacity has constricted.
Despite the difficult agricultural environment, farm real estate and equipment values have remained fairly resilient. Restructuring carryover debt has been a reasonable approach for borrowers with strong equity positions. However, given strained cash flow, debt service has been challenging for borrowers with even moderate levels of term indebtedness. As headwinds facing the agricultural economy persist, insured institutions must be prepared for agricultural borrowers to face financial challenges by employing appropriate governance, risk management, underwriting, and credit administration practices.”
The FDIC acknowledges some obvious points. Cash flows are break-even, and the solution for cash flow shortfalls has largely been to restructure against existing equity positions, particularly real estate. What is important, however, will be the FDIC’s approach moving forward, which can be interpreted as a structured, long-term approach to troubled relationships.
- A playbook for managing struggling agricultural relationships.
“Managing risk over the life of a loan includes: carefully documenting all lien perfections and other loan instruments; closely overseeing sale proceeds; conducting timely, independent collateral inspections; and developing a process for monitoring collateral values. A continuous credit grading program can help management identify credit risk early and take preemptive steps to prevent further deterioration. Assigning initial credit grades, ensuring timely grade changes, and assessing the adequacy of the Allowance for Loan and Lease Losses in light of grade changes are vital
According to this guidance, your ag lending playbook should include all of the following:
While relatively basic, this playbook can be difficult to implement consistently across troubled relationships. After all, some struggling borrowers may have been prime borrowers not that long ago, and implementing these risk-mitigating strategies can feel like a breach of trust between the lender and the borrower. This elevates the importance of ongoing conversations between the lender and borrower concerning operating results and overall performance expectations. Be sure these discussions are happening, especially with your less-seasoned lenders who may not have experience with difficult conversations.
- Documentation of lien perfections
- Oversight of sales proceeds
- Independent collateral inspections
- A monitoring process for collateral values
- An established and ongoing grading system
- A willingness to accept loan modifications as part of a long-term solution.
“Further, an institution that implements prudent loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse classification.”
The FDIC is communicating their willingness to accept modifications of loans, including loan terms, with or without concessions—especially in circumstances in which modified terms allow for a borrower to maintain positive cash flow, weather adverse conditions and stabilize their operations.
Remember, a classified loan is an internal measure. It is not public information. Your risk rating system should be established, implemented and reported in such a way that those charged with governance roles can be informed of management’s assessment of risk and strategic direction. However, don’t let a classified risk rating or Troubled Debt Restructuring get in the way of what is best for the bank and the borrower. You know your customers best.
Borrowers and bankers alike must adapt to a changing economy, unpredictable weather and policy changes. Understanding regulatory expectations, like those noted above, is crucial to navigating an uncertain agricultural economy.
How can you ensure proper direction for your ag lending?