46 July 1989
Western Journal of Agricultural Economics
setting with less attention given to the lender’s
process of credit evaluation, including the rel-
ative importance of the major variables af-
fecting credit worthiness.
In contrast, a growing set of studies (Luf-
burrow, Barry, and Dixon; Dunn and Frey;
Hardy and Weed; Fischer and Moore; Stover,
Teas, and Gardner) have focused on the credit
evaluation process, including the development
and validation of various types of credit scor-
ing models. Credit scoring provides a system-
atic, comprehensive way in which to assess the
borrower’s financial data and, along with the
lender’s judgment and other relevant infor-
mation, reach a valid assessment of the bor-
rower’s credit worthiness. The basic steps are
to identify key variables that best distinguish
among borrowers’ credit worthiness, choose
appropriate measures for these variables,
weight the variables according to their relative
importance to the lender, and then score each
loan as a weighted average of the respective
variables. The credit evaluation results then
may serve as the basis for risk-adjusted loan
pricing, as well as for assessing the quality of
loan portfolios, validating loan decisions to
other loan personnel and regulators, screening
loan applicants, and counseling with borrow-
ers.
But credit scoring studies also have been
static in nature; they have given little attention
to how the credit score would respond to se-
lected risk responses of borrowers, to changes
in borrower performance over time, or to the
relationship between the resulting credit score
and the price and nonprice terms of financing.
Thus, neither set of studies has integrated the
multiperiod analysis of business performance
with the lender’s methods of loan pricing, where
loan pricing is based on credit evaluations re-
sulting from this performance, in order to eval-
uate their joint effects. This study focuses on
the joint treatment of these relationships under
the premise that this approach will yield more
valid projections of farmers’ future financial
performance, given lenders’ greater use of ad-
justments in loan pricing as a response to
changes in a borrower’s credit worthiness.
Modeling Concepts
To illustrate the linkages among business per-
formance, credit scoring, and loan pricing, we
will initially abstract from the details of risk
and time by using a simple profitability model
in which the borrower’s rate of return (rɔ on
equity capital is expressed as the weighted av-
erage of the difference between the return on
assets (ra) and the cost of debt (z), where the
weights are the ratios of assets to equity (A∕E)
and debt to equity (D∕E), respectively, and the
profitability measure is net of the withdrawals
for taxation (/) and consumption (c):
(1) re = [rα (А/E) - i(D∕E)](l - Z)(l - c).
In turn, the interest rate on debt is a function
of the lender’s cost of acquiring loanable funds
(z}), the fixed costs of administering the loan
program (ia), and a risk premium (zr) attributed
to the credit worthiness and related lending
costs of individual borrowers (Lee and Baker):
(2) i = f(ifi ia, ir).
Assuming the lender uses the pool-of-funds
approach to funding individual loans (Hayes)
and allocates fixed lending costs among bor-
rowers in proportion to their loan volume—
both of which are typical in agricultural lend-
ing (Barry and Calvert; Barry, Baker, and
Sanint)-then the differences in interest rates
among borrowers are due primarily to differ-
ences in credit worthiness.1 Moreover, if credit
worthiness is evaluated on the basis of system-
atic, consistent procedures of credit scoring,
then the differential risk premium (ir) is a func-
tion of the variables and weights that comprise
the credit score. That is,
(3) zr = /(CREDIT SCORE)
in which
(4) CREDIT SCORE = f(aXi, a2X2, ..., anXn),
where Xn is the set of credit worthiness vari-
ables and a„ is the set of weights on the vari-
ables.
To illustrate the analytical effects of differ-
ential pricing on the borrower’s financial struc-
ture, assume that the credit score (and thus the
loan rate) is a function of only one variable—
the borrower’s leverage position as measured
by the debt-to-equity ratio (DIE). Moreover,
let the relationship be a linear function so that
z = ifa + b(D∕E) where ifa is the base rate de-
termined by the funding and administrative
l One exception occurs when loan pricing from a commercial
bank directly reflects the borrower’s deposit relationship with the
bank. In this case the loan rate may reflect the combined effects
of credit worthiness and the level of deposits held on account at
the bank.