Bankers must factor in climate risk in farm loans

The farm sector is heavily impacted by climate change. Ignoring this factor may spike loan defaults

Financing climate change adaptation and mitigation has gained traction in the national climate policy regime. However, accounting, or quantifying climate risk in lending has yet to generate a consensus among the regulator and scheduled commercial bankers.

Though the Reserve Bank of India emphasised climate risk-informed financing, there needs to be a unified approach to climate risk assessment and its incorporation in potential-linked credit plans in agriculture, the most vulnerable sector to climate risk.

It is worth noting that the potential-linked credit plan (PLP), devised by the National Bank for Agriculture and Rural Development in 1988-89, identifies sectoral potential and finance needs and prioritises allocation of funds.

This makes projections of credit requirements in agriculture considering their long-term potential availability of infrastructure, marketing support, credit absorption capacity, and status of the credit delivery system.

However, the current credit plan does not account for climate risk. So, what could be the ramifications on the refinance agency and scheduled bank’s priority sector lending?

First, crop and term loans in agriculture from 2004-05 to 2021-22 grew 16 per cent CAGR (see the Chart below).

The share of crop loans in total agriculture credit has declined from 2013-14, while the share of term loans increased from the corresponding period until the pre-Covid period.

The average shares of crop loans and term loans in agriculture are 67 per cent and 33 per cent, which means the crop loan portfolio is twice the term loan portfolio. Therefore, there is a need to quantify climate risk in terms of risk weights to crop- and area-specific scale of finance.

If bankers fail to account for climate risk while lending, there is a likelihood of defaults rising.

Second, linking credit with potential climate actions could help bankers revise their credit scoring model for potential borrowers to assess the potential credit risk and bankers’ perceived risk aversion and attract impact funds in agriculture.

POLICY SUGGESTIONS

The crop-wise scale of finance data needs to be tweaked to internalise the climate risk in priority sector lending. Agriculture insurers could help bankers quantify the climate risk.

Historical yield loss and premium data can be collected to estimate the crop loss ratio, which could be considered to estimate the average loss for insurers to indemnify the crop (yield) loss and maintain the (premium) rate adequacy compared to the loss percentage.

Bankers could decide their loan-to-value ratio based on the risk profiling of the district, the crops insured, and the farmers per their modified credit scoring model.

Fourth, default risk arising from the risk of crop (yield) failure captured in actuarial premium rates can push the bankers to add a spread to the cost of capital while lending to farmers and agri-value chain players.

The writer teaches at IIM Lucknow. Views expressed are personal. Inputs from Anindya Das of the GIZ India