How to Reduce Risk in Portfolios with Modern Risk Decision-Making

Traditional loan decision-making focuses on the financial risk of the borrower. But with the impact of climate change, increased regulations, and ESG reporting requirements on the horizon, these old-school approaches are no longer sufficient for reducing risk across an entire portfolio. Modern decision-making requires modern tools; risk factors should be viewed in a geospatial context that reflects this new reality.

According to the Harvard Business Review, many financial institutions haven’t yet adapted their decision-making approach for the 21st century:

“Rather than mitigating risk, firms actually incubate risk through the normalization of deviance, as they learn to tolerate apparently minor failures and defects and treat early warning signals as false alarms rather than alerts to imminent danger.”

In the agricultural sector, these warning signals include drought in the West, rising water prices in California, the growing prevalence of flood damage in agriculture, climate change, and regulation. These all illuminate the geospatial nature of loan portfolio risk. 

This post will be a guide for ag finance professionals to explain how to reduce risk in portfolios with modern risk decision-making tools that take the dynamic, geospatial nature of loan risk into account.

The Importance of a Sound Loan Portfolio

The U.S.D.A. identifies five main categories of risk in agriculture, including production risk, price or market risk, and institutional risk. Some types of risk have a greater impact on a loan portfolio than others, but all can contribute to “wide swings in farm income,” which may impact a borrower’s ability to remain afloat and repay their loans.

By using a modern decision-making process, financial institutions can ensure greater financial stability for both lenders and borrowers, which ultimately provides stability to the agricultural sector as a whole. 

A less-risky agricultural loan portfolio also means fewer environmental and social externalities, such as damage to ecosystems or nearby communities due to excessive water use or water pollution.

Farming operations that are climate and water resilient will be exposed to less risk in several areas, including disputes over water rights, reduced water allocations due to drought, and increased reporting requirements.

Because these risks are dynamic and geospatial in nature, however, identifying them within portfolios and mitigating them calls for modern risk decision-making tools.

21st Century Risks Require Modern Risk Decision-Making

Outdated methods of assessing risk – spreadsheets, paper documents, and non-digital tools – are now inadequate. Modern risks are more dynamic and complex than ever before, due to increased expectations of rapidity, changing climate patterns, and because the adoption of modern tools can cause a disparity between those who have them and those who don’t. A report in IOPScience points out that:

“Making decisions that take climate change into account are particularly challenging because climate change is difficult to observe, and accurate climate information is often not accessible…. Given the multidimensional nature of the climate, it is not cognitively easy to identify changes without extensive recording and processing of climate data.

Some of these risks include:

Droughts

From record heat waves in the Pacific Northwest to historically low water levels in key agricultural reservoirs, 2021 is already bringing significant drought-related challenges. Droughts are expected to increase in severity and become less predictable over the coming decades, raising the possibility of a multi-decade megadrought.

Flooding

While risk mitigation practices often focus on water conservation, floods can be just as damaging to farming operations as droughts. When rainfall occurs at the wrong time of year or in extreme quantities, it can lead to increased runoff and soil depletion, as well as damaged crops and drowned livestock.

Water Sources

It’s no longer enough for growers to rely on a single water source, whether it’s surface water rights or groundwater. Surface water can dry up, groundwater allocations can be capped, and the cost of water on the open market can increase dramatically in times of water scarcity. Ag finance professionals must factor water sources into their decision-making process.

Wildfires

Wildfires are also a risk factor for many farming operations, especially in times of water scarcity when dry conditions make fires more likely. Ag finance professionals must be aware of areas that are at high wildfire risk, and monitor any existing fires that could represent a threat to farming operations that are currently in a lending portfolio.

Soils

Soil quality can also impact a farm’s long-term viability, with short-term solutions often leading to diminished soil health. Another risk is land subsidence, in which the ground itself sinks as groundwater is pumped out of underlying aquifers. One town in Central California has dropped by more than 10 feet over the past several decades.

These are just some of the risks that can impact an agricultural lending portfolio. The common thread is that they’re all geospatial in nature, and require a geospatial data approach to data collection and decision-making in order to properly account for them.

How to Reduce Risk in Portfolios with Modern Decision-Making

Financial institutions are increasingly switching to digital, cloud-based tools in order to improve the decision-making process. 

Ag finance professionals with access to geospatial data management and decision-making tools will be more competitive and better able to make fast and accurate loan decisions

Recently, two startups came out ahead of traditional banks when it came to processing loans through the Paycheck Protection Program. According to the New York Times, one company “teamed with 17 lenders and processed 1.4 million loans, totaling more than $20 billion — about 7 percent of the total P.P.P. money given out this year.”

While that program isn’t specifically related to agriculture, ag banks and lenders can take advantage of similar tools in the ag finance industry. Cloud-based platforms can continuously aggregate data from multiple sources and present it in a geospatial format, illuminating connections – and risk factors – that might otherwise go unnoticed. 

In today’s world, the combination of environmental, social, and governance risks calls for a more fluid decision-making process. A modern approach to decision-making will help keep ag banks and lenders competitive in a changing financial environment.

Loan portfolios will be inherently less risky, ag finance professionals will be able to close loans faster, and they’ll be able to build better relationships with borrowers – all contributing to a more sustainable and water-resilient agricultural system built for the 21st century.

The Bottom Line

The traditional decision-making process for agricultural lending simply isn’t suited to the modern agricultural economy. Today’s ag finance professionals need access to dynamic, geospatial data in order to account for risk factors such as drought, floods, wildfires, water scarcity, and a changing regulatory environment. 

GIS tools can help ag finance professionals learn how to reduce risk in portfolios as well as save time and money by improving their operational efficiency and contributing to a modern decision-making process that accounts for 21st-century concerns.

AQUAOSO’s solutions are specifically designed to help with this process, providing a comprehensive overview of risk factors in a map-based, geospatial format. Users can toggle on and off specific layers, integrate third-party data sets using a secure API, and share reports with other stakeholders on a parcel-by-parcel basis. These tools can help with workflow management, cohort analysis, team collaboration, and more.

Contact AQUAOSO directly to learn more, or sign up for the newsletter to get the latest water security news curated for the agricultural sector.

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