S C -a C. : PF erC5 Fp F, u :5 FP Si S~ C p : SSSSpSSS C:F S3 5g SF C, SP- C:S (E l CONTENTS Page INTRODUCTION............................................3 Statement of the Problem.............................4 Objectives........................................7 Procedure ........................................ Bank Investments...................................10 Importance of Loans................................10 LOAN PROFITABILITY ANALYSIS............................. 7 BANKING STRUCTURE IN ALABAMA..........................8 15 15 Bank Objectives and Attitudes ......................... 17 Loan Portfolio Composition .......................... 20 Compensating Deposits .............................. 22 Direct Measures of Loan Profitability ................... 22 Administrative and Clerical Expense .................... Loan-Loss Expense..................................24 Comparisons of Relative Profitability................... 25 26 CONCLUSIONS ............................................ SELECTED REFERENGES...................................27 APPENDIX................................................28 FIRST PRINTING 3M, AUGUST 1980 Information contained herein is available to all persons without regard to race, color, sex, or national origin. AGRICULTURAL LENDING PROFITABILITY FOR ALABAMA COMMERCIAL BANKS MICHAEL W. MOORE and WILLIAM E. HARDY, JR.** INTRODUCTION THE AGRICULTURAL environment in the United States has experienced changes in recent years which have had important implications for agricultural finance. Major changes include the declining number of farms and improvements in efficiency made possible through the utilization of labor-saving machinery and other technological advances. The future structure of farming is highly dependent on the ability of farmers to secure adequate amounts of investment and operating capital. The ability of the agricultural sector to acquire sufficient capital has become a matter of concern to both farmers and managers of financial institutions. Similarly, the future structure of financial institutions serving agriculture will be determined by the way they perceive the changing financial requirements of the farmer and adjust to those needs. The relative importance of traditional agricultural lenders has changed over the past years. Federal Land Banks have emerged as the primary institutional supplier for farm real estate credit, lending $24.6 billion for real estate purchases in 1979, about 34 percent of the total market. Individuals were also very important, providing 34.3 percent of the total volume, $24,8 billion. This importance of individuals as a source of funds was emphasized during the tight credit periods of 1979. Life insurance companies were the third largest farm real estate creditor, $11.9 billion, followed by commercial banks, $8.6 billion, and the Farmers Home Administration, $4.4 billion (2). *Research on which this report is based was supported by Federal and State Research Funds under Hatch Project Alabama 476. *Former Graduate Research Assistant and Associate Professor, Department of Agricultural Economics and Rural Sociology. 4 ALABAMA AGRICULTURAL EXPERIMENT STATION The relative positions of these lenders in 1950 and 1979 are illustrated in figure 1. Commercial banks have long been the major source of nonreal estate credit in the United States, providing at least 40 percent of total each year since 1950. In 1979, they supplied $28.3 billion, 47.2 percent of the total market (2). Competition in this market has increased, however, with the Production Credit Association share rising from 7.5 percent in 1950 to about 25 percent in 1979. While the Farmers Home Administration and private individuals supply a substantial amount of non-real estate credit, neither offer a significant challenge to the major market portions held by commercial banks and PCAs. Figure 2 illustrates the market shares held by the principal non-real estate lenders in 1950 and 1979. Statement of the Problem Total farm debt in the United States increased from $10.7 billion in 1950 to $132.2 billion in 1979 - an increase of over 1,135 percent (2). During the same period, total farm production expenses went from $19.5 billion to $114 billion, a 435 percent increase (3). Total farm cash receipts rose about 359 percent, increasing from $28.8 billion to $132.1 billion (2). With both production expenses and total debt having increased faster than farm receipts, farmers who were once self-sufficient in terms of generating adequate capital to continue and expand farming operations, are less able to do so. Profit margins have narrowed and, subsequently, the farmer's ability to finance his operation with equity capital from profits earned in previous years has decreased substantially. In many instances, the increased utilization of credit has become a necessary component of the farm management plan. Increased dependence upon borrowed funds and leverage in farming developed from at least three occurrences: (1) The consolidation of agriculture into fewer and larger farms to achieve greater economies of scale from improved technology and management techniques; (2) High land values brought about by capitalization of the benefits of new technology, economies of scale, government payments, and increased demand for farmland from nonagricultural sources; and, (3) The increased substitution of purchased for non-purchased inputs, and the increased prices of these inputs caused by in- AGRICULTURAL LENDING PROFITABILITY 5 Federal I Land Bank 16.2% Life insurance companies 21/ Commercial banks 16.7%/ Farmers Home Administration 3.6%/ Individuals 42.5% 1950 Distribution Federal Land Bank 34.1/ Commercial banks I1I.80/ Life insurance companies 14.1%/ Farmers Home Administration 5.7%/ Individuals 34.30/ 1979 Distribution FIG. 1. Distribution of real estate debt by lending source, 1950 and 1979. 6 ALABAMA AGRICULTURAL EXPERIMENT STATION banks 39.8%/ Production Credit Associations 7.5%. Farmers Home Administration 45%/ 6.70/ Federal 1950 Distribution Intermediate Credit banks 1'% Commercial ,j banks 47.2%0 Credit 25%/ 19 79 Distribution FIG. 2. Distribution of nan-real estate debt by lending source, 1950 and 1979. AGRICULTURAL LENDING PROFITABILITY 7 flation. An obvious consequence of the increased use of borrowed capital has been growing pressure on financial institutions to provide more loanable funds. Commercial banks, as traditional leaders in supplying agricultural credit, have been among the first to feel the pressure of increased farm-loan demand. A major problem, faced by a large number of banks (previously involved to some extent with agricultural lending), is justifying farm loans in light of other investment opportunities. For agricultural loans to be included in a bank's loan portfolio, the loans must be perceived by bank management as contributing to the attainment of bank objectives. Banks, like other businesses, usually have profit maximization as their primary objective. Therefore, for bank management to commit funds to agricultural lending, those funds must be able to generate at least as much profit as they could in their next best use. Faced by this continuing pressure - from their stockholders to optimally allocate loanable funds, and from the agricultural sector to continue to provide large amounts of credit- commercial bank management is being.forced to reevaluate their lending and investment policies. Objectives The major objective of the study presented in this report was to examine the commercial banks' role in supplying agricultural credit in Alabama. Specific objectives were: (1) To examine Alabama banking structure and loan-investment portfolio composition; (2) To examine selected factors affecting loan profitability; and (3) To determine the economic feasibility of agricultural loans for commercial banks in Alabama. Procedure An analysis of the banking environment in Alabama was accomplished through the use of secondary data. These data were obtained from the Federal Reserve Bank of Atlanta, the Alabama State Bankers Association, and other selected sources. The "case study" approach was used to permit an analysis of the relative profitability and economic feasibility of various categories of loans made by Alabama commercial banks. Data were obtained from five banks which were geographically dispersed over the State representing the major agricultural areas-Wire- 8 ALABAMA AGRICULTURAL EXPERIMENT STATION grass, Lower Coastal Plain, Black Belt; Limestone Valley, and Piedmont. The agricultural lending officer, or an officer familiar with the bank's overall lending activity, was interviewed and asked to assist in collecting the detailed data necessary for the analysis. Bank policy permitted only bank employees access to individual customer records to prevent disclosure of confidential information. So complete anonymity of all data would be preserved, data were recorded by bank personnel on the questionnaire given in the Appendix (4). Specific information requested from each bank dealt with the following topics: (1) (2) (3) (4) (5) (6) (7) Bank objectives and management attitudes, Compensating balances, Loan volume, Loan losses, Loan-loss recovery, Bank personnel productivity, and Bank operating expenses. For comparative purposes, data were collected in five customer categories and four loan categories. Customer categories were: (1) active farmer, both proprietors and active farmers in a formal business organization, (2) retired farmers, (3) business organizations deriving at least 70 percent of their revenues from farmers, (4) nonagricultural commercial businesses, and (5) individuals not employed in a job directly connected with agriculture. Loan categories considered were: (1) agricultural loans, including production loans secured with real estate, (2) commercial loans, (3) installment loans, and (4) mortgage loans. BANKING STRUCTURE IN ALABAMA The data presented in table 1 show how the structure of commercial banking in Alabama has evolved during the past 10 years. Growth has been evident in all areas. Total deposits grew from just over $4 billion in 1969 to more than $12.6 billion in 1978. This growth in deposits can be attributed in part to three fundamental, interrelated factors: (1) The general growth of the economy during this period with the accompanying inflow of new sources of deposit funds into the banking system; (2) The contribution of bankers in soliciting new loan customers and thereby generating new money stocks which ulti- TABLE 1. SELECTED CHARACTERISTICS DESCRIBING COMMERCIAL BANKING STRUCTURE IN ALABAMA, 1969-1978' Characteristics National banks....................... National bank branches............... State banks ......................... State bank branches.................. Total banks ......................... Total bank branches.................. Total banks and branches............. 1969 1970 1971 1972 1973 1974 1975 1976 No. 96 299 206 176 1977 1978 C C-1 C cF LC No. 88 166 180 63 268 229 497 No. 88 188 184 77 272 265 537 No. 87 206 186 91 273 297 570 No. 88 225 189 104 277 329 606 No. 89 244 196 121 285 365 650 No. 92 264 201 143 No. 94 286 205 163 No. 97 311 211 182 No. 99 337 211 198 -I cD LF 293 407 299 499 302 475 308 493 310 535 LF 700 8,389 828 10,821 798 9,149 889 10,821 779 10,163 949 11,937 801 11,675 1,066 13,609 845 12,612 1,165 14,735 z D 0 11 Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Ml. dol. Total deposits .................... 4,289 5,023 495 5,736 5,764 547 6,603 6,788 609 7,802 Total capital accounts................ 405 4,803 Total assets............. 7,715 733 8,993 'These data were taken from selected editions of Polk's World Bank Directory. TABLE 2. VOLUME OF COMMERCIAL BANK LOANS AND PERCENT OF TOTAL BANK INVESTMENTS FOR ALABAMA, SIXTH FEDERAL RESERVE DISTRICT, AND NATION, 1969-19781 D F- Year Loan volume' 1969.................. 2,482 Alabama Percent of total investments 62.9 60.5 2,694 1970................. 60.4 3,153 1971................. 3,814 61.4 1972................. 64.9 1973..................4,588 40,26 67.3 5,187 1974................. 40,59 5,567 64.0 1975................. 44,02 65.5 6,536 1976................. 68.9 50,9] [6 7,847 1977................. 52,09 rr 69.0 8,053 1978.................. 'Data taken from reports provided by Federal Reserve Bank of Atlanta. 'In millions of dollars. Rnr Rnr Rnr Arr nn- Arr RR1~~/r ~~ C Sixth I Federal Reserve District Loan .n Percent of volun nee total investments 63.9 19,46 64 61.6 20,78 81 60.9 24,05 50 63.3 30,27 72 66.9 37,27 78 Nation Loan volume' Percent of total investments 286,750 297,897 327,656 388,593 460,143 509,531 69.5 66.8 65.9 67.9 70.2 72.3 65 96 25 93 ~r~ r\ 68.3 64.8 64.6 66.4 66.2 507,202 546,704 626,346 616,443 68.8 68.6 70.9 70.6 10 ALABAMA AGRICULTURAL EXPERIMENT STATION mately filtered through the economy and returned in the form of additional deposits; and, (3) The overall effect of inflation. The value of total bank assets in Alabama also showed substantial growth during this same period, increasing from $4.8 billion in 1969 to $14.7 billion in 1978. On a per bank basis, assets grew from $9.7 million in 1969 to $17.4 million in 1978. These growth figures indicate not only that Alabama banks have been a factor in economic development during the past several years, but also, because of their increased size, they have developed the potential to facilitate further economic growth and development of their communities. The distribution of banks throughout the State is such that accessibility is not a limiting factor ih the banking system's ability to serve the people. Another factor which has aided the development of better customer service is the expansion of branch banking in the State with the total number of banks and branches growing from 497 in 1969 to 845 in 1978. These added branches have given commercial banks a comparative advantage over other lending agencies. Bank Investments Three general criteria are often used by commercial banks in determining the components of their asset portfolio. These are liquidity, safety, and profitability. Liquidity is concerned with the very short-run situation, while the other factors are considered to be longer-run concepts. It is difficult to optimize all three measures. For example, in maximizing profitability, liquidity and safety often suffer. Holding all cash would be liquid and safe, but would produce no profit. Most assets of the earning portfolios of commercial banks are invested in loans and securities. The data given in table 2 indicate the prevalence of loans made by commercial banks in Alabama, The Sixth Federal Reserve District, and the Nation. Over the 10year period from 1969 to 1978, loans were at least 60 percent of the total portfolio. Also, relative to other investments, loans grew in importance. Importance of Loans Loans made by banks are typically grouped into one of five categories with classification depending upon the purpose, the type of borrower, or the collateral taken to secure the loan. The types of loans are: Mortgage or Real Estate; Farm; Installment; Commercial; and a general category, Other. Loan data pre- AGRICULTURAL LENDING PROFITABILITY 11 sented in table 3 indicate that, for Alabama banks, the only loan category showing any increase as a percentage of total loan volume was real estate loans, increasing from 18.7 percent of total loan volume in 1969 to 26.3 percent in 1978. All other loan categories remained relatively constant or declined slightly, with the "Other" loan category showing the largest decline, moving from 8.4 percent in 1969 to 5.1 percent in 1978. Similar changes in the distribution of loanable funds were observed for banks in the Sixth Federal Reserve District and the United States as a whole during the same 10-year period, tables 4 and 5. Real Estate loans increased relative to other loans for both Sixth District and U.S. banks. In both cases, these were the only loan categories showing increases as a percentage of total loans. Also in the commercial loan category, Sixth District banks showed a decrease from 31.5 percent of total loan volume in 1969 to 26.6 percent in 1978, while the same category for U.S. banks declined slightly more than 5 percent, from 37.8 percent to 32.6 percent during the same period. The "Other" category of loans showed decreases as a percentage of total loans similar to those of Alabama with Sixth District banks exhibiting a 3.3 percent decline and U.S. banks displaying a 1.7 percent decrease from 1969 to 1978. Several generalizations can be drawn from these loan data. The first, and most obvious, is that the credit needs of Alabama, the Sixth Federal Reserve District, and the entire United States have grown substantially, as reflected by the increase in bank loans in all categories. The second factor is that the percentages of total loan volume being made in each loan category have remained relatively constant during the past 10 years with the exception of a moderate decline in commercial loans in favor of real estate loans. In regard to farm loans and their relationship to lending practices of commercial banks, it may be concluded that one or more of four developments have taken place during the last 10 years: (1) Commercial banks have not recognized the credit needs that have been generated by the farming sector in recent years and have, therefore, not directed more of their lending activity toward these needs; (2) Commercial banks have been aware of the growing dependence of the agricultural industry for more credit, but have been faced with equally urgent credit needs from other segments of the economy; N TABLE 3. COMMERCIAL BANK LOANS BY TYPE, ALABAMA, 1969-1978' Type of loan Year Mortgage or real estate Pet. of Volume total Farms Pet. of Volume total Installment Pet. of Volume total Commercial Pet. of Volume total Other Pet. of Volume total Total Volume II- r V00 Mil. dol. 1969...................... Pct. 18.7 19.1 Mil. dol. 163 Pct. 6.5 6.2 6.0 Mil. dol. 885 Pct. 35.7 Ml. dol. 762 960 Pct. 30.7 Ml. dol. 208 Pct. 8.4 Mi. dol. 2,482 3,153 4,588 1970..................... 1971..................... 1972..................... 1973..................... 1974 .................... 1975 .................... 1976 .................... 1977 .................... 1978 .................... 492 603 465 18.3 20.4 20.8 174 229 276 195 6.4 6.0 6.2 6.5 6.0 6.0 5.7 951 1,148 35.3 36.4 37.1 868 1,091 1,298 32.2 28.6 208 305 357 779 1,064 1,188 1,540 1,988 2,114 955 1,410 1,702 37.0 35.6 34.9 34.7 34.9 34.9 30.4 28.3 247 7.7 7.8 8.0 7.8 2,694 3,814 5,187 5,567 6,536 7,847 8,053 C c- 20.5 21.4 23.6 25.3 26.3 322 363 393 468 462 1,847 1,944 2,266 2,741 2,810 1,551 1,623 1,856 2,168 2,258 29.9 29.2 28.4 27.6 28.0 403 449 482 483 409 7.8 8.1 7.4 6.2 5.1 C Mil) m i-I 'Data taken from reports provided by Federal Reserve Bank of Atlanta. x z m m O, -Z C) C C TABLE 4. COMMERCIAL BANK LOANS BY TYPE, SIXTH FEDERAL RESERVE DISTRICT, 1969-1978' m Z Total Volume Type of loan Year Mortgage or real estate Pct. of Volume total Farms Pet. of Volume total Installment Pct. of Volume total Commercial Pet. of Volume total Other Pet. of Volume total 0 F w C Mil. dol. 1969...................... 4,092 Pct. 21.0 Mil. dol. 954 Pct. 4.9 Mil. dol. 6,660 Pet. 34.2 Mil. dol. 6,130 Pct. 31.5 Mi. dol. 1,629 Pct. 8.4 Mi. dol. 19,464 1970..................... 4,375 1971..................... 5,220 1972..................... 7,016 1973..................... 9,158 10,603 1974 .................... 1975 .................... 11,192 1976 .................... 12,690 1977 .................... 15,207 15,835 1978 .................... 'Data taken from reports provided by 21.1 1,035 5.0 7,191 8,477 21.7 1,125 4.7 10,469 23.2 1,343 4.4 12,862 24.6 1,587 4.3 13,246 26.3 1,764 4.4 27.6 1,917 4.7 13,291 1,998 4.5 14,634 28.8 29.9 2,265 4.5 17,106 30.4 2,249 4.3 17,474 Federal Reserve Bank of Atlanta. 34.6 35.3 34.6 34.5 32.9 32.7 33.2 33.6 33.5 6,564 7,416 9,069 11,083 12,032 11,485 11,875 13,436 13,879 31.6 30.8 30.0 29.7 29.9 28.3 27.0 26.4 26.6 1,615 1,813 2,375 2,588 2,618 2,710 2,827 2,902 2,658 7.8 7.5 7.9 6.9 6.5 6.7 6.4 5.7 5.1 20,781 24,050 30,272 37,278 40,265 40,596 44,025 50,916 52,093 ah TABLE 5. COMMERCIAL BANK LOANS BY TYPE, U.S., 1969-19781 Type of Loan Year Mortgage or real estate Pct. of Volume total Farms Pet. of Volume total Installment Pet. of Volume total Pct. 22.1 22.1 22.7 22.5 21.7 20.3 21.0 21.7 22.4 23.2 Commercial Pet. of total Volume Mil. dol. 108,443 112,486 118,526 132,701 159,417 186,826 179,348 182,920 205,014 201,203 Pct. 37.8 37.8 36.2 34.2 34.7 36.7 35.4 33.5 32.7 32.6 Other Pct. of Volume total Mil. dol. 34,703 35,957 40,519 55,965 65,440 70,673 66,573 72,611 78,038 64,092 Pct. 12.1 12.1 12.4 14.4 14.2 13.9 13.1 13.3 12.5 10.4 Total W Volume Mil. dol. 286,750 297,897 327,656 388,593 460,143 509,531 507,202 546,704 626,346 616,443 > 2 Mil. dol. .. . 66,020 1969 ................... 68,165 .......... 1970 .......... 1971 .................. .. 77,432 93,652 1972 ..................... 112,638 1973 ..................... 124,681 1974 ..................... 128,533 1975 .................... 1976 ..................... 142,762 169,422 1977 ..................... 174,871 1978 ................... 1 Date taken from reports provided by Mil. dol. Mil. dol. Pct. Pct. 63,256 14,328 5.0 23.0 15,481 5.2 65,807 22.1 23.6 16,666 5.1 74,514 87,232 4.9 24.1 19,044 99,927 22,721 4.9 24.5 103,210 24.5 24,141 4.7 26,395 5.2 106,352 25.3 26.1 30,003 5.5 118,408 140,392 5.4 33,480 27.1 5.4 142,918 28.4 33,359 Federal Reserve Bank of Atlanta. 0 0 5 -I C > r m m m 2 o -4 -I 2~ AGRICULTURAL LENDING PROFITABILITY 15 (3) Commercial banks have recognized the importance of meeting farm credit needs, but have not perceived farm loans as contributing significantly to the attainment of bank objectives; and/or (4) Commercial banks have felt that earnings from lending to customers other than farmers were greater. LOAN PROFITABILITY ANALYSIS The following sections present an analysis of the data obtained from the five case study banks. The information indicates the relative importance of agricultural customers and their associated transactions with the bank. Bank Objectives and Attitudes Each banker interviewed was asked to rank nine, short-term management objectives in order of their perceived importance, table 6. This was requested to obtain a clearer understanding of the five banks' goals and objectives in establishing bank policy and designing their loan operations. Although more than one of the nine objectives could be used in the decision-making process, and interaction would almost certainly exist among the objectives, the respondents were asked to indicate which particular objectives would influence their decisions the most. Profit maximization was given the highest average priority by the respondents. Three of the five bankers ranked this as their number one objective; however, one ranked this objective as the least important. Employee welfare was considered the next most important factor in formulating bank policy, followed by high productivity. The three least important objectives were seen as commercial bank leadership, structural efficiency, and organizational growth. The reason most often cited for low rankings was that if the other objectives were being met, the less important objectives should be indirectly achieved. While management of the study banks agreed that setting objectives was a desirable management concept, few of them actually had structured goals or objectives. All utilized some version of a profit plan in their operations, but rarely were specific goals set for bank concerns such as growth, losses, or productivity. Finally, all bankers interviewed agreed that more shortterm and long-range forecasting needed to be considered to help prepare their operations for service in the 1980's. In addition to information relating to general bank objectives, 16 ALABAMA AGRICULTURAL EXPERIMENT STATION TABLE 6. INDIVIDUAL RANKINGS AND AVERAGE RANKING OF BANK MANAGEMENT OBJECTIVES, ALABAMA CASE STUDY BANKS, 1979' Objectives Profit maximization ........... Employee welfare (satisfying the needs and wants of employees) ................ High productivity ............. Customer welfare (efficiently satisfying customers' needs.. Operational stability (minimizing risk and anticipating financial difficulties) ....... Social Welfare (involvement in community activities) .... Commercial banking leadership (innovation and leadership in Alabama banking) ....... Structural efficiency (organizing resources effectively) ................ Organizational growth (including loans, investments, and customer services) .................. 1"1" is most important and "9" is Bank 1 1 3 2 4 6 8 9 7 Bank 2 1 2 6 8 4 3 5 7 Bank 3 2 4 3 6 5 7 1 8 Bank 4 1 4 2 3 6 8 9 7 Bank 5 9 3 8 4 6 1 7 2 Average 2.8 3.2 4.2 5.0 5.4 5.4 6.2 6.2 5 9 9 5 5 6.6 least important. each respondent was asked to give the bank's attitude regarding lending policy. Loan officers were first asked to describe how their bank developed new agricultural loan customers within their service area. Three of the five respondents indicated that their banks did, in fact, have a progressive farm-loan program in which an agricultural loan officer had, as a responsibility, the active solicitation of new customers from the agricultural sector. This solicitation came mainly in the form of personal visits to existing and prospective farm customers to present the features and benefits offered by the bank to farm borrowers. Two banks did not actively seek new business from the agricultural sector. One banker indicated that he realized the importance of visiting prospective farm customers, but, because of the work load imposed on the existing lending personnel, no time was available for such activities. Another banker stressed that his bank was presently making as many farm loans as bank management felt was desirable and, therefore, was making no effort to attract new customers in this loan category. Whether farm loans were actively sought or not, all five bankers perceived farm loans as a desirable part of their bank's portfolio. When asked to justify this reasoning, frequently mentioned AGRICULTURAL LENDING PROFITABILITY 17 responses were: (1) "Farming is such an important part of our local economy that it benefits us and the whole community when we make these loans." (2) "Farm loans are generally safe loans, very few farm loans have to be written-off." (3) "The personal character of farmers, as a group, is very high, you can depend on an honest relationship with them." Of the above three responses, the first was unanimously stressed as the most important. All bank personnel interviewed recognized the necessity and corresponding importance of farmers in their community. This view is consistent with the results of studies which have attempted to identify and measure a "feedback rate" associated with agricultural loans, although not specifically referred to as such by the study banks (1, 5). Finally, the bankers were asked to project their farm lending activities for the next 5 years. Two saw their banks moving increasingly away from agricultural loans because of the strong competition from Production Credit Associations and Federal Land Banks. The specialized services offered by these two organizations were seen as a distinct advantage in serving the credit needs of farm customers. Two of the remaining three banks saw little or no change in the relative composition of their bank's portfolio in the next 5 years. They pointed out that while they realized the importance of agricultural lending in their community, credit needs from other segments of their service area were also projected to increase at a fast rate. The result for the bank was seen to be proportional increases in all loan categories. One study bank forecasted an increase in both the volume of agricultural loans and the relative percentage of this type loan in the bank's loan portfolio. Three primary reasons given for this prediction were: (1) The continued importance of farming in the local economy; (2) Bank management's perception of the importance of meeting the credit needs of farmers in order to foster economic growth and development within the community; and, (3) The attitude of farm-lending personnel in seeking new farm-loan customers. Loan Portfolio Composition The five case study banks averaged a loan-to-deposit ratio of between 62.4 and 72.2 percent from 1973 to 1977, table 7. 18 ALABAMA AGRICULTURAL EXPERIMENT STATION TABLE 7. LOAN-TO-DEPOSIT RATIO, ALABAMA CASE STUDY BANKS, 1973-1977 Case study banks Bank 1 ....................... Bank 2 ...................... Bank 3 ...................... Bank 4 ...................... Bank 5 ...................... Average ...................... 1973 Pct. 44.5 75.9 45.3 71.5 74.9 62.4 1974 Pct. 51.7 74.6 57.5 71.0 77.5 66.5 1975 Pct. 53.2 70.9 84.3 68.8 70.2 69.5 1976 Pct. 65.1 71.5 72.8 71.2 73.5 70.8 1977 Pct. 69.3 71.7 77.1 72.7 70.1 72.2 Changes in bank management and acquisition by a holding company were the two reasons suggested for the relatively large increase in loan-to-deposit ratios for banks one and three. Both of these banks indicated that as new management personnel were introduced into their banks as a result of a holding company acquisition, new, active, and progressive lending programs were implemented. The remaining three banks maintained a more stable ratio throughout this period. The actual voluhime of loans in each category, along with the percentage each represented of total loan volume, is presented in table 8. Total loan volume rose from an average of $55.6 million in 1973 to $84.3 million in 1977 for an average yearly increase of 12.9 percent. Over this period, an average of 35.7 percent of these total loans were for the financing of real estate (mortgage loans), with the balance, 64.3 percent, being allocated among the various classes of non-real estate loans. Agricultural loan commitment for each bank was derived by summing the farm loans reported in the Quarterly Call Report Data and farm-operating loans which were secured by real estate. The five study banks averaged more than $7.6 million of agricultural loans in 1977 or slightly more than 9 percent of their total loan volume. This compares with $1.5 million and approximately 6 percent of total loan portfolio for all Alabama banks in the same year (3). Average farm-loan commitment for the case study banks increased at an annual rate of 22.7 percent from the $4 million level in 1973. Over this same period, commercial loans increased at an annual rate of 6.5 percent, installment loans grew at a 10.3 percent rate, and mortgage loans increased at a 20.0 percent rate. This large rate of increase in mortgage loans likely came from the increased desire of banks to take real estate as collateral for the other loans. Although annual growth during the 5-year study period was greatest for farm loans, consumer installmeint credit received C, C C m z TABLE 8. AVERAGE LOAN PORTFOLIO COMPOSITION, ALABAMA CASE STUDY BANKS, 1973-19771 1973 Vol. 4,000 Farm ......................... 16,000 Commercial ................... 15,853 Installment .................... Mortgage..................... 18,545 582 Other.......................... 55,580 Total........................ Loan category 'In thousands of dollars. Pct. 7.2 29.9 28.5 33.4 1.0 100 1974 Vol. 5,094 17,231 16,948 20,856 567 60,696 Pct. 8.4 28.4 27.9 34.4 .9 100 1975 Vol. 5,693 17,721 18,556 2,425 680 65,075 Pct. 8.7 27.2 28.5 34.5 1.1 100 1976 Vol. 6,720 20,109 19,038 26,507 502 72,876 Pct. 9.2 27.6 26.1 36.4 .7 100 1977 Vol. 7,639 20,185 22,379 33,390 739 84,332 0 Pct. 9.1 23.9 26.5 39.6 .9 100 D' w r- to 20 ALABAMA AGRICULTURAL EXPERIMENT STATION more emphasis than any other loan category. Bank loan officers interviewed believed this to be the most desirable loan because of its high yield and quick "turnover" characteristics. Also, the market for installment loans permitted higher interest rates to be charged. Compensating Deposits Compensating balances indirectly influence loan profitability in that they help reduce risk, assist a bank in meeting its reserve requirements, and provide funds for additional bank loans and investments which in turn increase the bank's total income. It was, therefore, considered important to study the level of customer deposits, or compensating balances, which farmers and other groups held in the bank. None of the case study banks required compensating balances as a prerequisite for making a loan, but all agreed that funds being held on deposit by loan customers were a positive factor in attaining the profit objectives of their banks. For an assessment of deposit balances by customer type, deposit data were obtained from each of the five case study banks. Accounts within each customer category were randomly chosen to get the following total sample: 90 active farmers, both proprietors and active farmers in a formal farm business organization; 84 retired farmers; 72 agribusiness or business organizations deriving at least 70 percent of their revenues from farmers; 70 nonagricultural commercial businesses; and 90 individuals not employed in a job directly connected with agriculture. An average checking deposit balance was determined for each customer within the various classifications by utilizing a 6-month average balance (the most recent 6 months) or averaging the checking balances on the 15th and 30th day of the most recent month. The particular method used depended on the accounting practices used by the bank supplying the data. Also, savings and certificates of deposit balances were determined for each customer by examining their current level of deposits in each of these categories. As illustrated in table 9, the case banks' agricultural customers (active farmers, retired farmers, and agribusinesses) accounted for about 68 percent of the average total deposits for the group total. With a $14,395 average total balance, active farmers maintained almost twice the funds deposited by individual non-farmers. AGRICULTURAL LENDING PROFITABILITY 21 TABLE 9. AVERAGE CUSTOMER DEPOSIT BALANCES, CASE STUDY BANKS, 1977 Customer category Number of and deposit type Active farmer...........................90 Checking ............................. Savings .............................. . C .D .'s.............................. Total .................................. Retired farmer .......................... Checking............................. Savings .............................. C.D .'s................................ Total .................................. Agri-business ......................... Checking ............................. Savings .............................. C .D.'s ................................ Total .................................. Commercial busine...................... Checking ............................. Savings .............................. C.D.'s ........................... Total .................................. Other individuals ....................... Checking .......... Savings .............................. C .D.'s ................................ Total .................................. customers Bank Av. Dol. 6,897 .1,296 6,202 14,395 84 5,414 3,411 23,601 32,426 72 22,323 .1,530 7,580 31,342 70 13,582 1,063 14,040 28,685 90 2,100 1,378 4,478 7,956 The retired farmer group averaged over four times the level of deposits of individual non-farmers and more than twice the level of active farmers. This group of bank customers was included to emphasize the benefits that can accrue to banks which maintain a strong farm-loan program. The general consensus among management of the study banks was that retired farmers tend to stay in their local community after retirement and continue to do business with the bank they have traditionally used. As a result, this group tends to maintain sizeable deposits with their local bank. Banks can use these funds for reserve requirements and new loans or other investments. This customerbank relationship should weigh heavily as a factor in establishing farm-loan policy. Considering the business categories, agribusinesses were found to maintain a slightly larger total deposit balance than commercial, non-agricultural businesses. The largest difference between agricultural and non-agricultural businesses was that 22 ALABAMA AGRICULTURAL EXPERIMENT STATION non-agricultural businesses had an average C.D. balance two times as great as agribusinesses. The average deposit balance for the "individual" category was by far the lowest of the five groups sampled. The $7,956 value represented only 7 percent of the total average deposit balances of all customer categories. Direct Measures of Loan Profitability Profit is normally considered to be the return that a business receives in excess of its costs. The most accurate reflection of the overall profitability of a bank's lending operations is given on the year-end Call Reports under the heading "net operating profit before taxes and security transactions." This value may be related to other data on bank size and activities to determine relative profitability. Table 10 gives three ratios calculated from the Call Reports of the case study banks indicating their levels of profits. The average profit-to-loan ratio of 2.18 percent for the study banks gives an indication of the relatively low rate of return and small profit margin received from the loan portfolio. The overall profitability of bank lending is determined by the difference between the gross return received from the loan, the interest, and the costs associated with granting and servicing the loan. These costs may generally be grouped into two basic categories: the administrative and clerical expenses associated with interviewing the applicant, preparing the necessary paperwork, examining the collateral, and making collections; and the loss realized from the loans that become uncollectable. TABLE 10. AVERAGE OPERATING PROFITABILITY RATIOS, ALABAMA CASE STUDY BANKS, 1977 Profitability measures Net operating profit Total assets ............................................... Net operating profit ............................. Total deposits ................ Net operating profit ................ Total loans..................................... Percent 1.19 1.66 2.18 Administrative and Clerical Expense The productivity of bank personnel in making and servicing loans directly influences the profitability of bank loan operations. Increased personnel efficiency in administering loans will increase the net profit margin for the bank loan department. Data were obtained from each of the five study banks to indi- AGRICULTURAL LENDING PROFITABILITY 23 cate the levels of administrative and clerical expenses associated with the lending process. Bank officers who provided the data for this study were asked to indicate the total number and type of bank personnel involved with the bank's loan operations, the portion of time that each spent in the lending process, and the salary of each individual involved. Total anonymity was preserved since no names were used and general terms were used to describe positions. In addition, the time that each individual spent in the lending function of the bank was allocated to the following loan categories: (1) Farm loans, including farm loans secured with real estate; (2) Commercial and industrial loans; (3) Consumer or personal installment loans; and, (4) Mortgage or real estate loans. These data were assimilated to construct productivity measures for the personnel and to estimate the administrative and clerical costs of lending, table 11. Basic productivity standards were loan volume per employee, loan volume per dollar of salary, and a similar measure, salary expense per dollar loaned. TABLE 11. AVERAGE PRODUCTIVITY OF BANK PERSONNEL BY LOAN CATEGORY, ALABAMA CASE STUDY BANKS, 1977 Loan category Loan volume/ employee . Dol. 3,236,779 3,923,929 1,478,620 5,697,924 Productivity measure Loan volume/ total salaries Dol. 224 240 99 580 Salary cost/ dollar loaned Pct. .45 .42 1.01 .20 Farm .................... Commercial ............ Installment.............. Mortgage ............... Loan volume per employee reflected the efficiency of the bank work force in the lending activity. Productivity in mortgage loans was greatest, an average of $5,697,924 per individual. Typically larger sizes of mortgage loans tended to make this value relatively high. Commercial loan activity was the next highest, followed by farm loans and installment loans. Characteristically small installment loans made bank personnel productivity in this area relatively low. The relation of loan volume to salary gives an indication of how much the bank is getting in return for its investment in personnel. Again, size of loan directly affects this measure with mortgage lending being the highest, $580, and installment lending being the lowest, $99. The farm and commercial categories fell between 24 ALABAMA AGRICULTURAL EXPERIMENT STATION these extremes at $224 and $240, respectively. Perhaps the most valuable relationship from a profitability viewpoint is the ratio of total salary expense to loan volume. These values reflect the cost per dollar loaned and may be compared directly to the interest earned on a loan to get a net return. The data show for each dollar of mortgage loan, administrative and clerical expense amounts to 0.20 cents or 0.2 percent. Comparable values for commercial, farm, and installment loans are respectively, 0.42, 0.45, and 1.01 percent. These values appear to be very small, but when compared to the 2.18 percent net operating profit of the study banks given in table 10, they gain added significance. Loan-Loss Expense Another factor considered to be important in influencing the profitability of bank lending operations was the amount lost through uncollectable loans. Average dollars of loss and recovery were determined for each category of loan and for total loans in each study bank from 1973 to 1977. Net loan-loss for each loan category was determined by subtracting the amount recovered from the amount originally lost. Losses and recoveries do not necessarily correspond each year. For example, a loan "written off" in 1973 may have been recovered in increments over the next several years. However, practices for all five banks were consistent in regard to loan-loss accounting so that these calculations were considered to be a valid measure of this profitability factor. Total net loan-loss, the average recovery rate, and net loss per dollar loaned in each category are given in table 12. The greatest amount of net loss for the study banks was in installment loans, 58.9 percent of total losses, with the least being in the farm category, only 3.4 percent of the total. TABLE 12. AVERAGE ANNUAL NET LOAN LOSS AND PERCENT OF TOTAL Loss, LOAN Loss/ DOLLAR LOANED IN CATEGORY, AND AVERAGE ANNUAL RECOVERY RATE BY LOAN TYPE FOR SAMPLE BANKS, 1973-1977 Type of Net loan Recovery Net loss/ loan Farm ................ Commercial ......... Installment ........... Mortgage............ loss Dol. 5,990 58,457 102,623 7,025 Pct. 3.4 33.6 58.9 4.1 rate Pct. 26.8 35.4 36.3 39.2 dollar loaned Pct. .10 .32 .55 .02 . The rate of recovery values indicate the relative percentage of past due loans eventually collected. Farm loans were the worst AGRICULTURAL LENDING PROFITABILITY 25 in this measure with a 26.8 percent recovery rate. The rate for mortgage loans was the best, 39.2 percent, indicating that eventual collection from those few who defaulted on a mortgage was more likely than the other categories. When viewed in proportion to the total loans in each category, installment loans had the greatest amount of loss, .55 percent, or 55 cents per dollar loaned. Mortgage loans had the smallest rate of loss in proportion to amount extended, .02 percent. The rate of loss per dollar loaned in the farm and commercial categories was .1 percent and .32 percent, respectively. Again, these values seem small, but are significant when compared to net profit percentages. Comparisons of Relative Profitability The cost of loans made in each of the categories-installment, farm, commercial, and mortgage-may be compared by combining administrative and clerical costs with loan-loss expenses, table 13. These total-cost-per-dollar-loaned values give a true indication of relative profitability. Installment loans are, by far, the most expensive, and mortgage loans are the least costly. Loans for agricultural purposes cost one-third as much as those in the installment category. TABLE 13. TOTAL COST (ADMINISTRATIVE AND LOAN-Loss) PER DOLLAR OF LOAN, BY LOAN CATEGORY, CASE STUDY BANKS, 1977 Loan category Installm ent .................................................. ................................................ Commercial... Farm ......................................................... M ortgage .................................................... Percent 1.56 74 55 22 The relative profitability of farm loans, as compared to the other categories, may be seen more clearly if differentials are calculated, table 14. These differences may be referred to as interest rate buffers. They emphasize that sufficient variation in cost exists among loan types so as to negate profitability comparisons based entirely on interest rates charged on a given loan. The interest rate buffer between farm and installment loans was nearly two times larger than the buffer between farm and commercial loans. The yield buffer between farm and mortgage loans has a negative value, -.33 percent, as both loan personnel and loan-loss expenses were proportionally less for mortgages. The implication of these calculations are significant for bank management as well as the farming sector - a farm loan made at 8.0 percent interest would compare in terms of profitability (as 26 ALABAMA AGRICULTURAL EXPERIMENT STATION TABLE 14. INTEREST RATE BUFFERS FOR COST COMPARISONS, CASE STUDY BANKS, 1977 Loan category comparison Farm to installment .......................................... Farm to commercial .......................................... Farm to mortgage ............................................ Percent 1.01 91 33 defined in this study) with a 7.67 percent mortgage loan, an 8.19 percent commercial loan, and a 9.01 percent installment loan. CONCLUSIONS The favorable profitability of farm loans, as identified by this study, suggests that bank management should rationally include farm loans as components of the total loan portfolio. Given that farm loans foster business activity in the local economy, banks making loans of this type would enhance their own level of banking activity by supplying credit needs of farm customers. An increased level of deposits and other bank business (trusts, estate planning, farm management, and tax services) can continuously accrue for banks actively involved in agricultural lending. Finally, banks choosing to make farm loans can make a return on loan investment comparable to most other loan alternatives they could consider. From the standpoint of the farming sector, banks which continue to actively engage in agricultural lending provide an alternative source of credit and thus promote the competitive nature of farm lending in Alabama. AGRICULTURAL LENDING PROFITABILITY 27 SELECTED REFERENCES (1) BARRY, PETER J. "Rural Banks and Farm Loan Participation," Amer. Jour. Agri. Econ. Vol. 60, No. 2 (May 1978). (2) MELICHAR, EMANUEL, AND MARTHA WALDHEGER. Agricultural Finance Databook. Division of Research Statistics, Federal Reserve System, Washington, D.C., November, 1979. (3) MOORE, MICHAEL W. "An Evaluation of Agricultural Loan Profitability for Commercial Banks in Alabama," M.S. Thesis, Auburn University, 1979. (4) Moss, JERRY L. "Profitability of Agricultural Loans for New York Commercial Banks," M.S. Thesis, Cornell Univ., Ithaca, 1977. (5) PODOLECKI, VERA B. "Loan-Deposit Linkages at Rural Texas Banks," M.S. Thesis, Texas A&M University, 1977. 28 ALABAMA AGRICULTURAL EXPERIMENT STATION APPENDIX Questionnaire Used For Case Study Analysis BACKGROUND INFORMATION SHEET Name Age Home Address Date MATI OR Home Telephone Number Business Telephone Number Education Present Occupation (including job title) Years of Service with the Bank (including positions held) Farm-Related Experience Previous Employment AGRICULTURAL LENDING PROFITABILITY 29 OBJECTIVE LIST Pleaserank the following commercial bank objectives in descending order of importance (assume a short-term perspective of up to two years). _ _ _ _ _ A. Commercial Banking Leadership (being innovators and leaders among the Alabama Commercial banks) B. High Productivity (getting the most from the resources available) C. Employee Welfare (striving to satisfy the needs and wants of banking personnel) D. Operational Stability (minimizing risks and anticipating future financial difficulties) E. Profit Maximization F. Social Welfare (being involved in community activities) G. Organizational Growth (expansion of services, portfolio, or volume of loan customers) H. Customer Welfare (endeavoring to most efficiently satisfy the needs of customers) Structural Efficiency (organizing resources in their most effective order) 1. 20 RANDOMLY CHOSEN ACTIVE FARMER "COMPENSATING BALANCES" CustNome Ave. Checking Ave. Savings C.D.'s aneop CA 0 C) C m x m --I O~ -Z 20 RANDOMLY CHOSEN RETIRED FARMER "COMPENSATING BALANCES" Customer No. Ave.ChkigAv ecing i avingsalance Ave. Comp. Be D C C m z v 0 '1 w r- 20 RANDOMLY CHOSEN OTHER INDIVIDUALS "COMPENSATING BALANCES" CustomerAve. No. Ave. Checing Ave. SavingsCBalance Comp. C C x z m V m z 20 RANDOMLY CHOSEN AGRIBUSINESS RELATED "COMPENSATING BALANCES" Customer No. Ave. Comp. Ave. Checking Ave. SavingsBalance C) C C z c) 0 an D 0- CA wA 20 RANDOMLY CHOSEN COMMERCIAL BUSINESSES "COMPENSATING BALANCES" CustomerAve. No. Ave. Checking Ave. Savings C.D.'s Comp. Balance C C r- m x z m m -O 20 RANDOMLY CHOSEN AGRICULTURAL BORROWERS & LOAN CLASSIFICATION Customer Customer No. $ Short Term 1 $ Int. Term _ _ _ _ _ _ $ _ _ Term Lung _ _ C _ C m 0 z G) 0 w r- 20 RANDOMLY CHOSEN INDIVIDUAL BORROWERS AND LOAN CLASSIFICATION Customer No. $ Short Tri$ht Term $In._er__$_onTr wA i$LogTr r- 00 C C r- x m mi m z -I -I 0 20 RANDOMLY CHOSEN AGRIBUSINESS RELATED BORROWERS & LOAN CLASSIFICATION Customer No. $ Short Term i $ Int. Term i $ Long Term C C- C m z m 0 '1 r 20 RANDOMLY CHOSEN COMMERCIAL BORROWERS & LOAN CLASSIFICATION Customer No. $ Short Term i $ Int. Term i $ Long Term w 0 C -I C x m mI z -a -I O0 LOAN VOLUME FOR LAST FIVE YEARS (1973-1977) (As Submitted for Call Reports) Year 1973 1974 1975 1976_________ 1977 __________ _________ __________ _ D- C Other Total Loans C Farm Loans Commercial Installment Loans Mortgage Loans CI m z 0 z ___________ _________ _ '1 w r- TOTAL NUMBER OF LOANS MADE IN LAST FIVE YEARS BY LOAN CATEGORY Year 1973 1974 1975 1976 1977 ________ ___________ __________ Farm Commercial Installment Mortgage Other Total ________ ___________ __________ w 0 LOAN LOSS AND RECOVERY FOR LAST FIVE YEARS (1973-1977) Year Farm Installment Mortgage Loss Rec. Loss Other Total Loan Loss Loss 1973 1974 1975________ 1976______ Rec. Loss Rec. Rec. w C _ C ______ _____ _____ _ 1977 ______ _____ m x -oi m z -a C, DI OI 0 AGRICULTURAL LENDING PROFITABILITY 41 ADMINISTRATIVE PERSONNEL AND PERCENT TIME LENDING & ADMINISTERING LOANS BY LOAN CATEGORY Name Farm Commercial Installment Mortgage Other Total Salaries, Wages, and Benefits for These Individuals 42 ALABAMA AGRICULTURAL EXPERIMENT STATION CLERICAL PERSONNEL AND PERCENT TIME ADMINISTERING LOANS BY LOAN CATEGORY Name Farm Commercial Installment Mortgage Other Total Salaries, Wages, and Benefits for These Individuals AGRICULTURAL LENDING PROFITABILITY 43 SELECTED INFORMATION FROM CALL REPORTS FOR LAST FIVE YEARS (1973-1977) Operating Income ....................................... Int. & Fees on Loans ...................... Other Income............................. Operating Expenses ...................................... Salaries, Wages & Benefits.................. Loan-Loss Prov............................ Int. on Deposits........................... Other Expenses ........................... Occupancy Expense ....................... Income BT & ST ........................................ Income After Taxes ...................................... Income AT & ST ........................................ Total Bank Assets ........................................ Total Liabilities ......................................... Deposits................................................ Demand ................................. Time & Savings........................... Reserve for Loan Loss.................................... Recoveries Credited to Reserve -............... $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Losses Charged to Reserve................................ Alabama's Agricultural Lxperiticiit Station System AUBURN UNIVERSITY tirai V\ ith an a ricuI ri 'sarrtihi unit inl _ uhurn l'ni ,crt t serves the nteeds of field croip, liv 'stock, forestl-\, ud h tictuuril p roducer', ,klihanli. lx enritn i Zeln of) the Stile has' 1 stakxe in this research hrurtvl, since alx hcal xxia s of hri' )t ltt uc ink; anld hinldIingf farm prolutis diretl txbenetits the e )lSUntlig publ ic. Research Unit Identification ® Main Agricultural Experiment Station, Auburn. SE. V. Smith Research Center, Shorter. 1. 2. 3. 4. 5. 6. 7. 8. Tennessee Valley Substation, Belle Mina. Sand Mountain Substation. Crossville. North Alabama Horticulture Substation, Cullman. Upper Coastal Plain Substation, Winfield. Forestry Unit, Fayette County. Foundation Seed Stocks Farm, Thorsby. Chilton Area Horticulture Substation, Clanton. Forestry Unit, Coosa County. 9. Piedmont Substation. Camp Hill. 10. Plant Breeding Unit. Tallassee. 11. Forestry Unit. Autauga County. 12. Prattville Experiment Field, Prattville. 13. Black Belt Substation, Marion Junction. 14. The Turnipseed-Ikenberry Place, Union Springs. 15. Lower Coastal Plain Substation, Camden. 16b Forestry Unit. Barbour County. 17. Monroeville Experiment Field. Monroeville. 18. Wiregrass Substation, Headland. 19. Brewton Experiment Field, Brewton. 20. Solon Dixon Forestry Education Center, Covington and Escambia counties. 21. Ornamental Horticulture Field Station, Spring Hill. 22. Gulf Coast Substation, Fairhope.