Tighter controls on farm lending

Sixty-four per cent of farm debt is in the dairy sector. Photo / Christine Cornege

The Reserve Bank has raised the amount of capital banks must hold to back their lending to farmers.

The changes have been well flagged, however, and deputy governor Grant Spencer said they would have only a minor effect on rural loan margins, as the banks had already adjusted their pricing considerably over recent years.

While tougher risk-weighting rules will require the banks to hold more capital against their rural loan portfolios than they have since 2008, it will still be lower than it was before that year.

Farm lending represents about 15 per cent of banks' total lending.

It is heavily concentrated, with 64 per cent of farm debt in the dairy sector, and the most indebted 10 per cent of farms carrying 45 per cent of the dairy sector's total debt.

Farm debt grew rapidly in the last decade reflecting a doubling in land prices between 2003 and 2008 as banks competed for market share amid easy credit conditions.

Since then land prices have retreated somewhat, and both borrowers and lenders have become more cautious.

This has occurred against the backdrop of a changing international regime governing the capital adequacy rules for banks.

Under the Basel II regime, which came into effect in 2008, the four largest locally incorporated banks were able to use their own internal risk models to determine the risk-weighting of their loan books for capital adequacy purposes. Initially that meant dropping the weighting for farm loans from 100 per cent under the Basel I rules which had prevailed for the previous 20 years to around 50 per cent - similar to residential mortgages.

The Reserve Bank, which was the regulator, was never happy with this and in two cases required the banks to hold additional capital, while it consulted on a regime which in its view would take better account of the key risk factors.

These are the possibility of large falls in farm land prices, the extent to which a bank's rural lending is diversified, for example between sectors such as dairy, sheep and beef, and horticulture, and the term of farm loans.

Shorter terms in general carry lower risk weights, but the Reserve Bank concluded this overstated the extent to which the risk was mitigated.

"When it matters, the effective or economic maturity of the loan will be longer than the contractual maturity," the bank says.

Banks tend to exercise a high level of forbearance with their rural clients, due in part to recognition of the cyclical nature of farm earnings and the long-term nature of these lending relationships.

Spencer said the new, more conservative risk weights would ensure banks were better prepared for any extreme shock to the rural sector.

"The Reserve Bank expects the new average risk weight across these banks will be about 80 to 90 per cent," he said.

"This is an increase on existing risk weights. However, it is important to note that before 2008, that before the Basel II capital regime was introduced, this figure was 100 per cent."