Financial institutions interested in serving this market face myriad risks and challenges associated with agricultural production and lending, including seasonality and the associated irregular cash flows; higher transaction costs; and systemic risks, such as floods, droughts, and plant diseases. While these challenges apply generally to smallholder lending (in fact to all agricultural lending), it is more challenging to serve some smallholders than others. With smallholders in “tight” value chains—where a strong relationship between the farmer and buyer exists—such relationships can be leveraged to reduce the costs and risks of agricultural lending through shared credit screening, monitoring and collection, and/or use of alternative collateral, such as sales contracts. The challenges become greater when trying to provide financing to smallholders in “loose” value chains, particularly for low-value staple crops, where farmers do not have strong relationships with other value chain actors. The challenges are compounded when trying to provide financing to subsistence farmers.
The spectrum of financial institutions involved in financing agriculture is broad, and seemingly reflects the farmers’ segmentation, as the importance of banks diminishes as the farmer clientele becomes smaller in scale and as value chains become less defined. The relative importance of different channels for different segments, however, is for the most part unknown. In particular, the evidence of microfinance institution (MFI) involvement in financing commercial and semicommercial smallholders remains anecdotal and lacks specifics on what makes MFI lending to these segments feasible, and what restricts their reach and effectiveness.