Better understanding and more structured pricing could help mitigate the effect of climate risk in lending, according to a new study by Monash University.
As farmers across the world continue to experience financial hardship due to the ongoing COVID-19 pandemic, the study showed borrowers in drought-prone areas were charged more interest on their bank loans than borrowers in other areas. The effect is substantially higher for borrowers in the food industry.
Using a sample of US private bank loans from 1984 to 2016, the research from the Monash Business School found a business in the food industry with a loan of around US$402 million paid more than US$280,000 each year in additional interest, compared to a borrower in a low drought-prone area.
However, they found a better understanding of drought risk by lenders by banks can lower this risk premium for agricultural borrowers.
While the study is based on US data, the researchers say these lending measures could also benefit Australian farmers.
Dr Viet Do, Dr Hannah Nguyen, Professor Cameron Truong and Dr Tram Vu from the Department of Banking and Finance, and Department of Accounting, in the Monash Business School contributed to the research titled ‘Is drought risk priced in private debt contracts?’. It was published in the International Review of Finance.
Dr Vu said the team is already looking to extend this project into the Australian market. They have already reached out to a number of Australian financial institutions, the Bureau of Meteorology and Australian farming groups to investigate how drought risk could apply to future lending models.
“The vast majority of Australian agricultural businesses are family owned and they often have very strong equity on the balance sheets. This is because farms are inherited through several generations and equity accumulates over time”, Dr Vu said.
“But lenders today are looking at how drought conditions affect borrowers, especially those in the food industry, and the additional layer of risk this poses to both parties. Lenders then attach an interest premium to this new factor.
“Drought is a relatively new type of risk and lenders are still learning to price it appropriately. However not all banks price drought risk equally. For example, less experienced lenders, in trying to protect their exposure, may have a tendency to overprice drought risk, leaving farmers at a huge economic disadvantage.”
The study used the Palmer Drought Severity Index (PDSI) to measure drought – the most widely used index in climatology research to evaluate the severity and frequency of abnormally dry periods.
While the study shows US borrowers couldn’t avoid the drought risk premium entirely, it was possible to mitigate it.
“Drought-affected borrowers appear to receive more competitive pricing when acquiring loans from more experienced banks”, Dr Do said.
“Borrowers with easy and affordable access to capital markets, for example, investment-grade borrowers, also faced a lower premium for their drought risk exposure compared to unrated and non-investment grade firms.”
Dr Nguyen said policymakers in Australia and across the world must consider the impact of weather and climate risk on borrowing costs in order to design subsidy programs for vulnerable groups of borrowers in the agricultural sector.
While integrating weather and climate change risks into the lending process, Professor Truong said the lending process could prove to be challenging, with tools and best practices not yet established.
“Australia’s agricultural sector is reeling in the wake of the COVID-19 pandemic – for some, it might take years to recover. It’s important that Australian lenders take financial and emotional hardship into consideration should they implement a drought risk policy to ensure they don’t place additional burden on our farmers,” Professor Truong said.
