Agricultural market risk: Abnormally normal

Risk management departments, which oversee agricultural markets, are present in broadly two types of institutions.

The first type are in the, “me too” category, by that I mean that these institutions are large and have a great focus on many asset classes including agriculture. In these types of institutions, agriculture asset exposure is very small.

The second type of institutions is where agriculture asset is the key asset to be managed. The focus in the second type of institutions is managing overall agri-business.

The key difference is that the risk management innovation happens in the first set of institutions and the second set of institutions borrows the model and applies it to suit its needs. In either case we have a problem.

Let us consider the first set of institutions where agriculture is in a “me too” category. Typically, banks are such institutions where they have either a large lending or derivative exposure to the agriculture assets.

These institutions have, over the years, developed tools for risk management, which focus on assets such as fixed income, foreign exchange, credit, etc. These asset classes have few things in common such as the availability of large pools of data, immense liquidity and a mathematical framework that can explain their asset price behaviour (not every time but most of the times!).

Now given the size of the agricultural exposure relative to these other asset classes, these institutions do not have an incentive to develop tools to accommodate the vagaries of the agricultural markets.

Agricultural exposure is very limited relative to other exposures in a bank.

Agri assets The above situation leads to some easy assumptions. First, fitting the agriculture assets into a pre-existing framework of risk management.

Second, over simplifying properties of agricultural markets making it normally distributed, or top it up with a mean reversion, and dump a seasonality assumption.

This does solve one problem, namely management can show regulators that they have a department focusing on this asset class. Little does the management or the risk managers know how this market behaves.

The second set of institutions is the one which understands every bit of the agricultural markets. They are fortunately and unfortunately ignorant of the behaviour of the other asset classes.

The unfortunate part pushes them to outsource the risk management methodology. They end up buying tools from the first set of institutions and try to adapt it to their local environment.

The fortunate part of ignorance helps them to stay away from oversimplifying things and trying to relate non-relatable assets. The second set of institutions is usually corporations involved in agribusiness.

Risk management Risk technology transfer from the first set to the second set of institutions in itself is risky. First, the banks could take inordinate amount of tail risk.

Second, banks could become overcautious cutting their agribusiness exposure sub optimally. This results in lower returns for both the lender and borrower.

Third, lack of incentives to create new model for agricultural asset class leads to an intellectual barrier insurmountable by the risk managers.

Fourth, corporations end up paying for risk management tools, which are worth a fraction of what they pay for. This leads to inefficient transfer of capital from corporations to banks.

The solution to the above problem needs to be addressed by the both sets of institutions together, but the lead has to be taken by the corporations.

They have the intellectual resources to direct the solution design. The banks can play a pivotal role in lending their infrastructure to the corporation for such a solution design.

The writer is based in London and is the founder and Managing Director of OpalCrest (www.opalcrest.com).

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