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Bankers' willingness to lend depends upon their being confident that the loan will be well used and repaid. With inventory credit, they need to be reassured that their physical collateral is totally secure, that its physical integrity will be preserved and that it will not be misappropriated under any circumstances.
ALTERNATIVE APPROACHES
Several alternative approaches to implementation have been identified:
(a) centralized warehouses or silos managed by a specialized warehouse operator, which does not trade in the items stored, but simply holds the stock as security for bank lending;
(b) centralized warehouses or silos operated by a specialized warehouse operator, which also acts as a channel for bank lending to a number of individual borrowers (alternatively, banks could operate warehouses directly or through subsidiary companies);
(c) centralized warehouses managed by a storekeeper, who is also a trader;
(d) warehouses operated by individual borrowers, under the supervision of a surveillance company;
(e) warehouses operated jointly by the borrower(s) and a bank under a dual-key arrangement.
The limited experience to date suggests that in countries which are establishing inventory credit arrangements for the first time, approach (a) is likely to have the best prospects. Its principal advantages are the high degree of security it gives lenders, by assuring that the warehouse operator is independent of the borrower, its contribution to the transparency of the trading system, and the fact that it avoids the administrative complications of a dual key arrangement in (e).
Approach (c) is widely practiced by larger trading companies in Europe and North America. Storekeepers offer farmers the choice of either storing their crop or buying it from them, though when storage is in short supply, they may only offer to buy, as this allows the storekeeper greater profit. Such arrangements are likely to evolve as countries become more developed. In Brazil, the warehousing law was recently amended to allow warehouse operators to trade on their own account.
In countries which have little experience in commercial storekeeping and no effective law for the regulation of warehousing practice, banks are likely to prefer approach (a). This is because it eliminates risks that the warehouse operator will be bankrupted by trading activities, and thereby risk the viability of the entire lending operation.
Approach (d) may be attractive in cases where warehouses are too small for a storekeeper to operate economically. In other cases, a single borrower may buy so much produce that he or she can fill a single store. In these circumstances, the bank may be content for the borrower to hold the stocks, providing that they are regularly inspected by a surveillance company. If the borrower disposes of the grain without the bank's authorization, the bank can bring criminal charges. This is the approach adopted successfully in the Philippines (Case Study 1).
In approach (a), bankers' confidence in the integrity of the collateral is assured by a highly professional warehouse operator, but in the Philippines this is done in another way: a government-owned corporation underwrites the banks' lending. Moreover, the parastatal grain trading organization undertakes to buy up any unsold stock at an official floor price.
The first approach is discussed in greater detail, as this is seen as the most viable approach in countries with little experience of inventory credit. The Philippine model has interesting features, but may be inappropriate in countries trying to rid themselves of interventionist policies, since the creation of official guarantee funds and floor prices creates opportunities both for special interest lobbying and abuse of state power. One characteristic of the scheme is that it is supported by an interest-rate subsidy. Due to this subsidy, it is not known whether the scheme increases millers' propensity to store, or whether it simply finances storage which, in its absence, would be financed in other ways.
MECHANICS OF INVENTORY CREDIT
There are three essential parties (see Figure 1) to a commercial inventory credit scheme of scheme type (a).
FIGURE 1. Essential parties in inventory credit
The procedure for lending, storing and repayment works as follows (it is assumed that the produce stored is grain).
(a) Well in advance of the harvest, the borrower applies for credit facilities to be made available against presentation of warehouse receipts.
(b) The bank approves (or rejects) the application, based upon the criteria it has developed for this kind of lending. It will probably fix a "cash credit limit" up to which it will lend for the next season. At this time a tripartite agreement may be drawn up between the bank, the borrower and the warehouse operator (see Annex 3).
(c) At harvest time the borrower has grain which he or she has bought or, in the case of larger farmers, was produced by the farmer. After drying and cleaning the grain, he or she takes it to the warehouse.
(d) The warehouse operator checks that the grain meets minimum quality standards which have been established for content of moisture, foreign matter, live insects, etc. If it meets the standards, it is accepted for storage and the borrower is given a warehouse receipt showing the number of bags, the weight and the quality of the produce received (see Annex 4).
(e) The borrower presents the receipt to the bank as security for a loan. As approval has already been given up to the cash credit limit, the loan is made immediately. This avoids time-consuming procedures whenever the trader deposits grain in the store. The bank makes the loan based on the current market valuation of the grain. Usually, it will lend up to a given percentage of the value of the grain deposited, e.g. 80 percent, requiring the borrower to finance the "margin" of 20 percent from his own resources. The term of the loan will be related to the annual price pattern; the borrower is required to repay before the time when prices normally pass their seasonal peak.
(f) The borrower may now use the loan proceeds to purchase more grain either for trading or for further deposit in the warehouse. The warehouse receipts may be used as security for further loans, and so on. In this way a borrower may greatly increase his or her funds invested in grain stocks. Take, for example, a trader who starts with an initial stock of 100 tonnes of grain purchased with his own funds. After pledging three times, he or she may have bought three times as much grain as he or she would have purchased without access to inventory credit:
Impact of inventory credit on stockholding
Quantity purchased with loan of 80 percent (tonnes):
| Initial stock | 100 |
| Purchase with first loan | 80 |
| Purchase with second loan | 64 |
| Purchase with third loan | 51 |
| TOTAL | 295 |
The total shown only applies when the procurement price remains stable throughout the purchasing period. Since it generally rises, the borrower will, with each loan, be able to buy less grain than the amount shown. If this happens, it may be justified for the lender to revalue the entire stock in store, and recalculate the borrower's entitlement accordingly.
(g) Grain belonging to individual borrowers may either be stored separately from that of other borrowers (i.e. "identity is preserved"), or mixed with grain belonging to other borrowers ("identity is confused"). In the latter case, the grain which the warehouse operator finally issues is of a standard quality, but is unlikely to be the same lot which was originally deposited in the warehouse. The pros and cons of preserving identity are set out on page 16.
(h) The borrower withdraws the grain when he or she wishes to sell it, probably in the lean season, either in one lot or in separate tranches. To withdraw grain the borrower must first settle his or her bills with the warehouse operator and repay the bank with accumulated interest and bank charges. However, in practice, the bank may allow its good customers to obtain release of the grain before repaying the loan.
PROS AND CONS OF PRESERVING THE IDENTITY OF PRODUCE
The advantage of confusing the identity of produce is that it allows for economical use of grain cleaning and drying equipment,: and of storage space, and makes for faster movement in and out of store. For this reason, the warehouse operator in the Ghanaian case study, which has a network of silo sites with grain dryers and cleaners, is following the policy of confusing identity (see Case Study 4). In situations where warehouse operators have large dryers (e.g. requiring a minimum batch of 20 tonnes), they may have little choice but to confuse identity. Most depositor borrowers are unable to till the capacity of the dryer on each occasion it is used: some mixing inevitably occurs. Similar considerations apply to the use of large silos.
Warehouse operators which have drying and cleaning equipment are able to bring heterogeneous lots down to a uniform quality standard. Based on a knowledge of initial and final moisture content and the quantity of foreign matter and damaged grain removed, the warehouse operator can tell each depositor borrower how much grain he or she should receive upon receive upon issue.
An advantage of preserving identity is that it helps develop trust between the depositor borrower and the warehouse operator. As in the case in India (Case Study 2) the depositor borrower knows that he or she will get back the same grain he or she deposited, and will not be subsidizing others who deliver produce of poor quality. A further advantage of preserving identity is that it allows warehouse operators to operate more flexible quality standards and grading criteria. Grain is stored providing it is sufficiently dry and meets a minimum standard for foreign matter, etc., but it need not meet a uniform trade standard. Traders will sometimes prefer this arrangement, as it means they can minimize loss of weight through grain cleaning.
Preserving identity is, therefore, likely to prove most attractive in situations where traders are unsophisticated and reluctant to trust their grain to safekeeping by others- in drier climates where grain does not need rnechanica I drying prior to storage; and where there is an abundance of inexpensive warehouse storage, permitting storage of small, discreet lots without jeopardizing the profitability of the warehouse operator.
(i) In the event that borrowers fail to repay the loan fully by the due date, the bank will be authorized to seize and auction the grain. If proceeds are not adequate to cover the full amount, the bank should follow its normal procedures for recovering overdue debts.
Seven key requirements for the successful implementation of inventory credit are outlined here.
For many readers, this observation may seem obvious. However, it is a principle which can often be overlooked where governments and development assistance programmes are concerned, as illustrated by the schemes implemented for traders in Mali (Case Study 3). In this case it appears that the banks and one of the storekeepers saw inventory credit more as a public service function to be carried out on behalf of Government or donors, rather than as a long-term business venture to which they themselves were committed.
Those wishing to promote the development of inventory credit should seek out banks which are financially sound, have adequate resources for lending, are interested in expanding their clientele, have a record of innovation, and are known for their speed of operation and their willingness to adapt loan conditions to changes in the condition and pattern of trade. It should not be assumed that "agricultural banks" or "rural banks" are suitable. Notwithstanding their mandate, they often fail to fulfil these essential criteria.
There should be no political pressure to lend and, generally speaking, special lines of credit or specific central bank rediscounting facilities should be avoided. There may be a special case for the latter when there is a severe seasonal credit shortage.
In line with this thinking, warehouse operators should not be required to carry out costly social roles on behalf of Government, for example, to receive uneconomically small lots of produce. Situations where warehouse operators required minimum amounts of produce to operate their dryers economically (e.g. 20 tonnes) are referred to on page 16. Even where dryers are not needed, warehouse operators will always need to establish minimum lot sizes, since handling, weighing, quality control and administrative costs are all high when receiving a few bags at a time. Preserving identity of small individual lots will also make for high storage costs. Likewise banks will incur high costs when processing very small disbursements. For these reasons, the best way of providing inventory credit to small farmers or small traders is by encouraging them to associate into informal groups or cooperatives, and thereby bulk-up volumes which are economical for the warehouse operator to handle.
The concern for profitability also means that inventory credit should not be exclusively for a single commodity, e.g. maize, but should be open to any commodity for which traders need to obtain finance against their stockholding. The range of commodities stored by traders is likely to include items such as coarse grains, rice, fertilizer, seed, cement, sugar, tea, cocoa, coffee, dried fish and grain bags. A caveat must, however, be added for those cases where equipment, physiological or phytosanitary problems limit the range of products which can be stored together.
An important aspect of inventory lending is that the borrower has some initial equity in the form of grain which he or she has bought or, in the case of the farmer, has produced. This stock is deposited as collateral for credit. As noted earlier, lending will usually be for less than the market value of the grain, so that a borrower continues to have some equity tied up in the stock.
For the borrower, this is the most important requirement. It is vital to avoid unnecessary red tape and guarantees which slow down the lending process without a commensurate increase in security. Funds should be disbursed to borrowers immediately upon presentation of warehouse receipts.
Traditional bank evaluation procedures can be followed at the time the trader initially applies for a line of credit. Subsequently, however, loan disbursement and repayment procedures must be more or less immediate in order to permit the trader to take advantage of profitable trading opportunities. Moreover, branch managers should have certain discretionary limits up to which they may release funds to customers without reference to higher authority.
A problem noted in the Ghanaian case study (Case Study 4) is that banks which are unfamiliar with inventory credit tend to apply ground rules developed for other forms of lending, which are inappropriate for this type of trading where speedy decision-making is of the essence. This is particularly the case when borrowers are asked to put up real estate as collateral, in addition to inventory.
It is understandable that banks seek this additional security from borrowers who can provide it, but valuations and searches tend to be extremely time consuming. Insistence upon real estate as security shortly before the onset of a harvest may cause the borrower to lose the opportunity to buy produce when prices are lowest. Instead of enhancing the security of the loan, the mechanical application of standard rules reduces the profitability of the borrower's operation, and thereby diminishes the bank's security.
The same is true of rules requiring borrowers to have a full set of accounts and to present projected cash flow statements for the period of the loan. Many of the most capable grain traders are in the informal sector and do not keep detailed accounts. Some may be illiterate. This is not to say that they should not be encouraged to keep records, but the inflexible application of such ground rules may bias lending in favour of more educated borrowers lacking the necessary experience to operate successfully as traders. This again renders lending less rather than more secure.
The most important criterion for inventory lending should be the borrower's professionalism and track record in the business concerned. Any reputation and credit history that the borrower may have should also be taken into consideration. Thus, references should be given far more weight than the provision of real estate or keeping of elaborate formal accounts, although some form of record will be required in order to establish the maximum level of credit which should be extended.
Ultimately, bank lending is about managing risk: how banks can approach this task in the case of inventory lending is discussed in Section 6.
It is not important for the warehouse operator to be a store owner; the operator may simply lease the warehouses or silos. It is preferable if the operator has the possession of, or access to, equipment for drying and cleaning produce, but even this is not essential. The warehouse operator can insist that produce brought to its store is dry and meets certain standards of cleanliness.
As regards efficiency and reliability, however, there should be no compromise. If the warehouse operator cannot ensure the physical security of the collateral, the banks will decline to lend. Failure in this regard was one of the main problems with the Malian trader schemes.
Good warehouse operators are most likely to be found if banks are responsible for their selection, since it is the banks which stand to lose most in the event of a poor decision. The following criteria are suggested for assessing suitability:
(a) access to suitably located storage facilities and, where needed, equipment for drying and cleaning produce;
(b) staff technically competent in grain handling and storage, including grading, quality control and fumigation;
(c) a good track record in the warehousing business;
(d) financial resources and reputation, as a guarantee that restitution will be made in the case of unsatisfactory performance of duties - the bank may alternatively seek a performance bond; (c)business skills, involving the speedy and efficient management of warehousing and warranting services, and good communications with customers and banks;
(f) an entrepreneurial outlook and ability to innovate - in order that inventory credit be made widely available, a warehouse operator will need to sell its services actively in different parts of the country where there are marketable crop surpluses, and among those seeking to use it in relation to international trade;
(g) motivated and, by implication, well-paid staff;
(h) the ability to withstand political pressure, such as pressure from a Government faced with a food emergency and seeking to requisition food stocks - for this reason, it may be preferable in some countries that warehouse operators be private sector organizations, oreven multinational companies (see also Sections 6 and 7).
It is possible for existing parastatal grain trading companies to become warehouse operators, but there are various problems associated with this option (see Section 7). Finding suitable private warehouse operators may also be difficult in some countries. Companies interested in warehousing may lack an adequate track record and/or net worth to satisfy the banks' requirements. There is also a danger of conflict-of-interest where prospective warehouse operators are reluctant to separate warehousing from trading activities, as required by the preferred approach (a) described in Section 2. In the absence of reputable warehouse operators, it may be best to involve companies which perform related services such as freight-forwarding, inspection and pest control. Such companies may operate warehouses as an adjunct to their core business and have access to the necessary skills. An alternative is for the banks to set up their own storekeeping subsidiaries, either individually, or with several banks acting in concert.
In some countries, the key to successful collateral management may be to involve major blue-chip companies, either multinationals or large national concerns, whose participation is seen by the banks as an assurance that any failure on the part of the warehouse operator will be made good. While multinationals are not immune from corruption, any more than smaller local companies and parastatals, they are likely to avoid any gross mismanagement or contractual failure that would damage their international business standing.
The blue-chip company will preferably, but not necessarily, be one with experience in the warehousing of agricultural commodities. It may operate as a storekeeper in its own right, or associate with a smaller local company with relevant skills. An example of such an association is that of a pest control company in Mali, which recently joined forces with a leading multinational superintendent company to inspect rice stocks pledged as security by a parastatal rice miller.
Market intelligence is essential for both lenders and borrowers in order to minimize the speculative risks involved in storing agricultural produce. In Africa, most governments have Early Warning Units producing crop forecasts, while some have Market Information Services (MIS) which disseminate price and other information.
These organizations provide valuable information but are usually underfunded. Generally, they have been initiated through donor programmes but attempts to incorporate them as part of ongoing programmes, without outside assistance, are often unsuccessful. They need strengthening and the range of information disseminated needs expanding to include items such as crop forecasts, prices in neighbouring countries, prospective imports and food aid arrivals. Sustainability can often be improved by reducing the number of crops, for which market information is collected, and the number of markets sampled. In setting up market information services there is often a temptation to try to maximize the amount of information collected without regard to its usefulness, or the cost of collection or processing.
Dissemination mechanisms generally need improving to ensure that traders and banks have ready access to the information. Radio stations, for example, are often unwilling to broadcast market information without payment of fees which government MIS can ill afford. One option may be to arrange for sponsorship of market information broadcasts. Banks can use this information as well as data from branch networks and informal trade comment. They should have the capability of collating these sources of information in order to assess lending risks. By correlating production and price data, and analysing historical data, they can better forecast price movements. Creating an analysis capability for a range of agricultural commodities may incur significant costs, and for this reason one possibility might be to centralize such services in an inter-bank organization created for this purpose.
The establishment of an inventory credit programme requires a careful analysis of the existing legal framework. Among other things, this will entail a review of laws and procedures relating to the sale of goods, secured transactions, and warehouse, banking and credit regulation. The main issues (discussed at greater length in Annex 2) are likely to be as follows.
There is considerable variation between countries in the amount of legislation on this topic. Civil Law (or Code Law) countries, including countries of Latin America and Francophone Africa, and those whose legal systems stem from the model of post-revolutionary France, tend to have a considerable amount of legislation. In Common Law countries, there is more reliance on customary practice. Nethertheless, three important Common Law countries, the United States, the Philippines (see Case Study 1) and India (Case Study 2) have comprehensive statutory frameworks.
It is stressed that the "practical" effects of a particular legal variable on the viability of inventory credit will usually not be evident from an examination of legal doctrine alone. Where the economics of the scheme are strong enough, and lenders are comfortable that the practical risks are small, they may be able to live with a certain amount of legal ambiguity. Where, however, the economics are unclear and the political and business culture is unaccustomed to what is being proposed, legal uncertainties may present another reason for sceptical participants, particularly banks, to turn away from an uncertain venture. Thus, the establishment of inventory credit may require some persuasive and creative contribution from lawyers or, in the final analysis, Iegislative reform.
Legal frameworks may be strong on paper but weak in practice. This is particularly true of legal provisions which specify the duties and responsibilities of warehouse operators, notable features of Philippine and Indian legislation. In some countries these provisions may provide real protection to a bank when dealing with a relatively unknown operator In other countries, the bank's only protection is its knowledge of the operator particularly regarding its competence, reputation and financial resources.
Even if legislation is not needed to establish inventory credit, it may be needed to convert receipts into negotiable documents of title. In the UK these are known as "bearer warrants".
Negotiability brings major advantages (an extensive discussion can be found in Annex 2). Upon receiving a negotiable warehouse receipt, the holder is entitled to the goods described in it, whatever the depositor or the warehouse operator has done to them in the meantime. Negotiability allows goods to be traded freely on the market by specification, i.e. without visual inspection of the commodity concerned. Produce is sold simply by endorsing the receipt in favour of the buyer. This helps reduce transection costs and facilitates the development of "forward" and "futures transactions" (see Section 9). If a contract specifies delivery at a certain date in the future, delivery can be carried out simply by the exchange of the receipt.
Negotiability requires the commodity concerned to be specified in terms of standard grades so that the produce can be sold without being seen. For commodities like maize, standard grades can be established by mutual agreement between the warehouse operators and the trade. Grading is further discussed in Section 8.
As indicated above, negotiability can greatly increase the attractiveness to lenders of using warehouse receipts as security. In the event of default by the borrower, the lender can simply sell the warrant to liquidate the collateral, instead of first having to take physical possession of the grain. Negotiability is also a precondition for the emergence of a secondary market in the debt, and gives the lender greater flexibility with respect to its loan portfolio.
Negotiability will depend upon the market's confidence in the warehouse operators that issue the warrants. Confidence can be adversely affected by fear of malpractice or negligence (e.g. not insuring the produce stored) and, with newer warehouse operators, lack of an established reputation in the field. This observation serves to re-emphasize the importance of reliable and reputable warehouse operators.
