The Basel Accords, Capital Reserves, and Agricultural Lending

Gary W. Brester and Myles J. Watts

Publication

Because of recent global financial crises, the safety and stability of financial institutions has become a leading worldwide issue. Various regulations have been introduced with the goal of avoiding future financial crises. However, these regulations are likely to have unintended consequences for the agricultural lending sector—especially for smaller, less-diversified lenders.

This paper considers the effects of one of these international regulatory responses: the Basel Accords.  The Basel Accords are structured around three pillars: measurement of risk, capital adequacy, and market discipline. At their essence, the accords are a set of banking regulations that strive to minimize the number bank failures. However, some of the accords have been criticized as being unduly burdensome—particularly for smaller banks—and blamed for increasing bank sizes.

One way to reduce the risk of bank failures is to increase capital reserves, which help banks offset unanticipated loan defaults. However, increases in capital reserves reduce banking profitability and can generate higher interest rates on loans. Through the use of a simulation model, this paper evaluates the impact of capital reserve requirements on lending return on equity. In addition, simulations are used to calculate the effects of loan numbers and portfolio diversifications on capital reserve requirements. This paper illustrates that capital reserve requirements decline as the number of loans increases and as loan portfolios are diversified. It also shows that the number of loans and portfolio diversification reduce capital reserve requirements.

These findings suggest that smaller lending institutions and traditional agricultural lenders will face pressure to increase loan portfolio diversity or reduce loan sector concentration. The alternative is to face higher capital reserve requirements which creates a competitive disadvantage for, especially, smaller rural banks. Furthermore, traditional agricultural lenders can expect increased competition for agricultural loans from non-traditional agricultural lenders.