provided by Research Papers in Economics
Credit Scoring, Loan Pricing, and
Farm Business Performance
Peter J. Barry and Paul N. Ellinger
In light of recent developments in agricultural credit evaluations, this study employs a
multiperiod simulation model that endogenizes farm investment decisions, credit
evaluations, and loan pricing based on the credit scoring procedures of agricultural
lenders. Model results show that credit-scored pricing yields time patterns of
performance, credit classifications, and interest rates that parallel the firm’s
investment, financing, and debt servicing activities. Moreover, the lender’s price
responses dampen growth incentives as credit worthiness diminishes, stimulate growth
as credit improves, and lead to similar capital structures over time.
Key words: credit, credit scoring, loan pricing, farm performance.
The combined effects of financial stress in ag-
riculture, deregulation of interest rates in fi-
nancial markets, and improved information
systems for lenders have brought significant
changes in credit evaluations, risk assessment,
and pricing policies in agricultural lending.
Loan evaluation at the customer level is re-
ceiving greater emphasis and loan pricing in-
creasingly is tailored to the risk characteristics
of individual farm borrowers (Barry and Cal-
vert). It has become common, for example, to
observe lenders who categorize borrowers into
several risk classes with higher interest rates
associated with higher risk classes (Schmiess-
ing et al.; Lufburrow, Barry, and Dixon). These
changes in the scope of risk assessment and in
the form of the lender’s response provide a
new setting for evaluating the relationships
among the lender’s credit evaluation, the terms
of financing, and the borrower’s business per-
formance.
Our purpose in this paper is to identify and
evaluate the linkages over time between busi-
ness performance and financing terms in a
modeling approach that endogenizes farm in-
vestment decisions, credit evaluation, and loan
pricing based on the credit scoring procedures
of commercial lenders. A multiperiod model
is developed to evaluate these linkages for a
Peter J. Barry is a professor of agricultural finance, and Paul N.
Ellinger is an agricultural economist, both at the University of
Illinois at Urbana-Champaign.
representative farm situation under alternative
investment strategies, economic conditions,
and beginning financial positions. In the fol-
lowing sections we further develop the con-
cepts and review the literature about credit
relationships and loan pricing in agriculture,
describe the modeling approach, discuss the
analysis and the results, and consider the im-
plications for agricultural finance.
Credit Concepts and Evaluation Procedures
Previous studies of credit relationships in ag-
riculture have shown that the responses of
lenders to the business characteristics and
managerial actions of farmers influence a
farmer’s total cost of borrowing through the
combined effects of the interest rate on bor-
rowed funds and a liquidity premium reflect-
ing the borrower’s subjective valuation of credit
held in reserve as a source Ofliquidity (Barry,
Baker, and Sanint; Barry and Baker; Chhi-
kara). In turn, these cost effects may influence
the optimal financial structure (leverage) and
rate of growth of a farm business as well as the
composition of its assets, risk management
practices, and other income generating activ-
ities (Baker; Barry and Willmann; Pflueger and
Barry; Sonka, Dixon, and Jones). However,
these studies mostly have focused on measur-
ing the nonprice responses of lenders, espe-
cially limits on credit availability, in a static
Western Journal of Agricultural Economics, 14(1): 45-55
Copyright 1989 Western Agricultural Economics Association