Default Risk in Agricultural Lending: The Effects of Commodity Price Volatility and Climate

This paper proposes and estimates a default risk model for agricultural lenders that explicitly accounts for two risks that are endemic to agricultural activities: commodity price volatility and climate. The results indicate that both factors are relevant in explaining the occurrence of default in the portfolio of a rural bank. In addition, the paper illustrates how to integrate the default risk model into standard techniques of portfolio credit risk modeling. The portfolio credit risk model provides a quantitative tool to estimate the loss distribution and the economic capital for a rural bank. The estimated parameters of the default risk model, along with scenarios for the evolution of the risk factors, are used to construct stress tests on the portfolio of a rural bank. These stress tests indicate that climate factors have a larger effect on economic capital than commodity price volatility.