Liability management and floating-rate loan pricing as risk responses by commercial banks in providing agricultural credit

Abstract

Availability of credit to the farm sector through commercial banks has been a topic of concern for more than a decade. This study examines an operating policy for commercial banks which would tend to increase availability of funds to farm borrowers. Liability management through purchased funds intermediation provides a means to access regional and national sources of funds through Fed funds purchases, Certificates of Deposits, and money market certificates. Using a floating-rate loan policy on loans funded through liability management issues, a bank limits its risk exposure and can provide greater funds availability for lending at a given risk level. Liquidity risk theory is applied to a portfolio revision model of a commercial bank. Covariance estimates are incorporated in a quadratic programming model of portfolio revision. Risk return frontiers are estimated assuming a fixed-rate loan policy with purchased funds. The difference in risk between the two operating policies allows computation of a risk premium associated with the liquidity risk of liability management with purchased funds. A floating-rate loan policy means the liquidity risk of purchased funds is carried by the borrower. Since the liquidity risk is transferred from the bank to the borrower, an expected reduction in the lending rate is possible which is consistent with the liquidity risk premium. A reduction in loan rates is dependent on the competitiveness of the banking market. A purely competitive market will likely force the initial offer of the floating-rate down by the amount of the liquidity risk premium, while a monopolistic market may keep from reducing the rate by the full amount of the risk premium. Implications of the results on bank management, funds availability to farmers, usury laws, and further research are discussed.