An analysis of the risk-return relationship in the primary agriculutral sector in the Western Cape from a commercial bank's perspective

ENGLISH ABSTRACT: The research report investigates the risk/return relationship in the primary agricultural sector in theWestern Cape from a commercial bank's perspective. The study investigated the correlationbetween credit risk and return within a randomly selected portfolio of agricultural borrowers.Different risk categories were investigated to detennine which category correlates best with return.The effect of below prime and above prime pricing on return was also investigated.The study was conducted in the context of the turmoil in financial markets since the beginning of2008, caused by excessive credit risks. This has led to the need for better regulation in the financialservices industry and better pricing decisions. Factors supporting this need for better regulationinclude securitisation of debt, consolidation, globalisation and the systemic risk that banks imposeon the economy. The Basel Capital Accord introduced new regulatory requirements for the bankingindustry to ensure more effective management of credit risk. Risk management processes inagriculture are also subject to the requirements of this accord.The agricultural sector is characterised by unpredictable climatological conditions, poorgovernmental support, low profitability, overcapitalisation and price volatility, which cause thissector to be especially exposed to credit risk. The credit risk of borrowers within the case studybank was measured in tenns of a default grade using a behavioural risk rating model. Risk ratingsare used for profitability analysis, risk management and regulatory reporting. These ratings areassigned during the annual review process, when borrowers are exposed to a business viabilityassessment.Banks incur risk costs when accommodating a borrower's credit risk, which has a negative effect onthe return that the borrower generates for the bank. This emphasises the importance of correlationbetween credit risk and pricing and by implication return for sustainable profit margins. Theresearch results indicated that no correlation exists between credit risk and pricing. This lack ofcorrelation can be attributed to eontracrual agreements, relationship banking, technologicalconstraints, asset growth, price sensitivity in the agricultural sector and the nature of the risks inagriculture.The study also found that a negative correlation exists between credit risk and return. This can beattributed to the fact that the higher the credit risk, the more economic capital is required to supportthis risk and the more it costs. This implies a lower return on capital. It is recommended that therisk/return relationship should be improved by reducing credit risk, increasing non-interest income,ensuring that new borrowers are priced adequately, differentiating the existing portfolio in terms ofvalue and improving the negotiating skills of bankers. No meaningful conclusion could be drawn with regard to the effect that below prime and above prime pricing have on return.