Boehlje, Michael

Gray, Allan W.

English

Research Papers in Economics

CHOICES
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1st Quarter 2005 • 20(1) CHOICES 15
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1st Quarter 2005 • 20(1)
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Restructuring of the Ag Lending Markets: 
The FCS Dilemma
Michael Boehlje and Allan Gray
The recent initiative by Rabobank to expand their busi-
ness in agricultural production lending in the United
States through the acquisition of Farm Credit Services of
America surfaced considerable debate about the appropri-
ateness and desirability of that acquisition. But in reality,
the question is much more fundamental: Given the dra-
matic restructuring of the agricultural capital markets with
respect to both the changing customer base and the chang-
ing competitors, how can the cooperative Farm Credit Sys-
tem (FCS) maintain its competitive position?
The Changing Customer Base
Farm and agribusiness firms are becoming increasingly
complex in their size, structure, organization, and interde-
pendent relationships. The financing needs and uses of
funds by these more complex agribusinesses are challeng-
ing traditional lenders to consider new lending policies
and procedures.
For example, many farms operate farming businesses
not only in different counties than their home base, but
even in different states or different countries. This broader
geographic domain challenges the delivery system of a
funding organization that does not match that domain.
Likewise, more farmers are entering value-added busi-
nesses and new ventures beyond the farm gate. Some of
these new ventures include such business arrangements as
value-added production systems in the livestock industry,
ethanol and biodiesel plants, and other downstream activ-
ity. Farmers are also acquiring assets in the input supply
sector of the agricultural industry and even in nonagricul-
tural sectors. This increased scope of business activity by
farmers challenges a lender who has limited capacity to
offer financial products and services in other industries.
Farmers are also increasing their financial product/service
demands, including cash management services, asset man-
agement services, risk management services, payroll ser-
vices, and so forth; a lender must offer a broader product/
service bundle to serve this increasingly demanding cus-
tomer base.
An additional change in the agricultural credit market
is how farmers may access their lender. Increasingly, food
companies and processors are developing qualified sup-
plier or franchise grower arrangements with a limited
number of preferred producers. These processors are serv-
ing as value chain coordinators and in many cases are facil-
itating their franchise growers’ acquisition of price
discounts and preferred customer relationships in the feed,
chemical, and equipment businesses. It is not illogical that
similar arrangements would be developed with credit or
financial providers. Thus, a value chain coordinator may
facilitate access on the part of their franchise growers to a
national or global lender who can provide the broader set
of products and services their growers need. In essence, the
traditional lenders to agriculture—commercial banks and
the Farm Credit System—may need to compete and col-
laborate with value chain integrators to provide total sys-
tems solutions including inputs, product merchandising,
risk management, and financial products and services to
growers participating in vertically aligned value chains.
In essence, the farm customer base is changing pro-
foundly in terms of the traditional domain and boundaries
with respect to geography, line of business, product/service
needs, business model, asset control, and utilization and
buying behavior.
The Changing Competitor Landscape
The US agricultural credit market has been dominated in
the past by domestic commercial banks and the Coopera-
tive Farm Credit System, but that dominance is increas-
ingly being challenged in a number of important
dimensions. The recent entry of Rabobank into the US
farm production lending market has resulted in a global ag16 CHOICES 1st Quarter 2005 • 20(1)
lender that is one of the highest
credit-rated banks in the world chal-
lenging US-based agricultural lend-
ers. Agriculture has suddenly become
a sector attracting global and interna-
tional bankers and is no longer the
exclusive domain of US-based lend-
ing institutions.
Noninstitutional lenders are also
important to the farm sector,
accounting for almost 25% of the
non-real estate and real estate credit
in agriculture (Ryan & Koenig,
1999). Captive finance companies, in
particular, have become much more
permanent in recent years with loan
volumes growing rapidly; it is esti-
mated that manufacturers and dealers
now have a 25% market share of the
intermediate-term non-real estate
debt market for commercial farmers
(Dodson, 1997). The recent expan-
sion of captive finance companies
appears to be driven more by per-
ceived profit opportunities in finance
rather than marketing strategies to
sell excess inventories, suggesting that
these companies are more likely to be
permanent participants in the market
than in the past.
Financial leasing arrangements
are also growing rapidly—estimates
are that one fifth of commercial crop
farmers lease machinery and equip-
ment (Dodson, 1997). In the
machinery, equipment, and facility
market in particular, leasing compa-
nies affiliated with manufacturers (as
well as independent leasing compa-
nies) are expanding volume at dou-
ble-digit rates. The unique financing
that captive financing and leasing
companies emphasize—along with
relatively efficient origination, servic-
ing, and collection procedures—fre-
quently enables them to provide
credit services at an equal or lower
cost and with more convenience than
traditional institutional lenders.
The FCS Challenges
The aforementioned changes in the
customer base and competitors
present challenges to lenders who can
not or do not respond in maintaining
their market position and presence. It
is essential for any lender to antici-
pate and respond to changing cus-
tomer needs and expectations, to
offer products and services that are
preferred in pricing, service, and
other features to that of the expanded
offerings of their competitors, and to
deliver that product/service effi-
ciently and effectively. Regulations or
business policies that limit a lender’s
responses to changes in the market-
place clearly put it at a competitive
disadvantage.
The Regulatory/Policy Challenge
A fundamental challenge that will be
faced by the Farm Credit System is
that of the regulatory and policy
regime that shapes its business focus
and activities. This challenge in real-
ity involves two interrelated issues:
(a) regulations that define the
domain of the Farm Credit System
with respect to customer and line of
business focus, geographic bound-
aries, and product/service offering;
and (b) Government Sponsored
Enterprise (GSE) status.
The first issue of focus and
domain of the Farm Credit System is
possibly the most straightforward to
assess. If the characteristics of both
the customers and the competitors
evolve as discussed earlier, the Farm
Credit System will be increasingly at
a competitive disadvantage in serving
that changing customer base. Dereg-
ulation with respect to a broader set
of loan products and financial ser-
vices that would be attractive to both
current and future grower and agri-
business customers, as well as other
businesses in rural communities,
would allow the Farm Credit System
to serve its current and prospective
future customers more effectively.
Furthermore, as will be discussed
shortly, a more diversified customer
base would allow the system to more
efficiently allocate its risk capital,
thus increasing its competitiveness
with other global financial institu-
tions.
However, broadening the scope
of lending and provision of financial
services does not come without a
cost. First, one of the benefits of
being a specialized lender is that of
understanding the industry and tai-
loring the product/service offering to
that industry. If broadening the focus
of the Farm Credit System results in
less effective and efficient delivery of
credit and other financial products to
its current customer base, FCS will
not be fulfilling its legislatively man-
dated mission, and the cost may off-
set the benefits. Furthermore,
attempts to expand lending authority
of the Farm Credit System will likely
be met with resistance from other
lenders—commercial bankers in par-
ticular. It is highly likely that the
quid pro quo required by commercial
bankers, if the Farm Credit System
were to obtain expanded lending and
financial service authority, would be
the elimination of GSE status and
favorable tax treatment received by
certain Farm Credit System entities.
The critical issue, then, is how
much the cost of sourcing funds
would increase without GSE status
compared to the cost reduction that
would occur if FCS were a more
diversified lender due to reduced
equity capital requirements per dollar
of loan funds. The costs and benefits
of GSE status can not be adequately
analyzed without taking into account
the prospects of a more risk-efficient
use of capital if the portfolio were
more diversified.1st Quarter 2005 • 20(1) CHOICES 17
The Capital Market Challenge
An increasingly important challenge
that must be faced by all financial
institutions (including the Farm
Credit System) is that imposed by the
capital markets to efficiently allocate
and utilize risk capital. This chal-
lenge will be intensified with the
phased-in implementation of the
New Basel Accord concerning alloca-
tion of risk capital for all financial
institutions worldwide. The increas-
ingly competitive market conditions
all institutions (including coopera-
tives) will face in sourcing equity cap-
ital and compensating providers of
equity capital at competitive rates of
return on their investment will
require financial firms to be more
prudent with the use of their equity
capital.
A fundamental tenet of risk man-
agement and efficient equity capital
allocation in any financial institu-
tion is that of diversification: Risk
can be mitigated and equity capital
most efficiently allocated when the
institution has a diversified (in con-
trast to a specialized) portfolio of
assets. This tenet is in direct conflict
with the specialized focus of FCS
lending that, as a function of regula-
tory policy and business practice, has
very explicit boundaries concerning
its geographic, line of business, prod-
uct/service offering, and market seg-
ment domains. In essence, the Farm
Credit System has been and contin-
ues to be a specialized lender that
cannot take advantage of diversifica-
tion to manage risk. System members
are thus forced to maintain a higher
equity capital position to manage
that risk compared to a more diversi-
fied financial institution. The system
may need to maintain its current
high level of equity capital—almost
double that of other financial institu-
tions—if it remains as a specialized
agricultural lender that cannot diver-
sify. However, it is clearly overcapital-
ized compared to a diversified lender
like Rabobank that can loan to many
different industries in many geo-
graphic locations in the world. More-
over, from the perspective of current
borrowers, this equity capital is
“locked up,” and consequently has
limited current value.
The “excess” equity capital con-
cern is very fundamental—one could
argue that if the Farm Credit System
operated without current geographic,
line of business, product/service
offering, and customer segmentation
boundaries, the equity capital
required would be reduced without
increasing the financial risk and
potential loss exposure of the system.
This concern was in fact acknowl-
edged by FCS of America when the
board reconsidered and rejected the
Rabobank offer, indicating it would
implement policies to more rapidly
redeem or repay its patron retains,
thus allocating retained equity capital
back to the shareholders.
But, a partial redemption of the
equity capital may not solve the fun-
damental problem of efficient risk
capital utilization—a specialized
lender by definition must maintain a
higher equity capital position to
manage the higher level of risk it
faces. Even further consolidation of
the current FCS entities would not
generate the risk mitigation advan-
tages of more line of business diversi-
fication. Over time, if capital market
investors, including those who pro-
vide equity capital to financial coop-
eratives such as the Farm Credit
System, recognize that they are not
and can not receive a competitive
return on that capital as long as the
institution maintains its specialized
focus, they will move their capital
elsewhere or support the transition to
more diversification, unless that
institution is clearly providing other
benefits not available in the market
place.
With the significant changes in
customers and competitors noted
earlier, it is likely to become increas-
ingly difficult for the Farm Credit
System to maintain its competitive
position under the current regulatory
environment that limits its scope. An
expanded scope could provide for a
system that is more responsive to
today’s competitive environment. In
addition, a broader scope for the sys-
tem may allow for a more risk effi-
cient allocation of equity capital that
would continue to attract investors.
However, an increase in scope would
require substantial changes in the
current regulatory environment of
the system, which may lead to the
loss of GSE status. In addition, a
broadening of scope and reduction in
regulatory requirements may lead to
further consolidation of the system.
These costs will need to be weighed
against the benefits of broader scope
as the system determines its competi-
tive strategy moving forward.
For More Information
Dodson, C. (1997). Changing agri-
cultural institutions and markets: 
The farm credit outlook. Presented 
at USDA’s Agricultural Outlook 
Forum ’97, Washington, DC.
Duncan, M., & Stam, J.M. (1998). 
Financing agriculture into the 
Twenty-first Century. Boulder, 
CO: Westview Press.
Moss, L.M., Barry, P.J., & Ellinger, 
P.N. (1997). The competitive 
environment for agricultural 
bankers in the U.S. Agribusiness, 
13(4), 431-444.
Ryan, J.T., & Koenig, S.R. (1999, 
February). Who holds farm oper-
ator debt? Special article in Agri-
cultural Income and Finance, AIS-18 CHOICES 1st Quarter 2005 • 20(1)
76 Economic Research Service, 
Washington, DC, pp. 47-52.
Michael Boehlje is a professor and
Allan Gray is an associate professor in
the Department of Agricultural Eco-
nomics at Purdue University.

Restructuring of the Ag Lending Markets: The FCS Dilemma

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