PRICE RISK MANAGEMENT AGRICULTURAL ON BANKING AFRACA 3 APRIL 2009

1. PRICE RISK MANAGEMENT AGRICULTURAL ON BANKING AFRACA3 APRIL 2009

2. Strategic Intent • Vision • Independent one-stop agricultural shop with a wider regional footprint • Strategic Objectives • To enable the Land Bank to deliver on development mandate • To promote and advocate for agriculture, rural development, land access and poverty alleviation • To mainstream development focus by consolidating and creating systems for development • To accelerate transformation of agriculture by implementing agricultural reform programmes (for sustainable emerging farmers) • To enhance agricultural development, rural development, and land access through innovative and foundational solutions

3. Land Bank Stratification Model Development path Commercial Growth Emerging Land Reform Time *Refer to Annexure B

4. Introduction • Market risk is the risk that factors that impinge on the market values of assets and liabilities of the Bank cold impact adversely on earnings and capital. In practice, the most important type of market risk for banks is the interest – rate risk. • This process of managing risk is best through of as a series of balancing acts: potential sources of funds should be balanced against the likely need for funds; the interest-rate sensitivity of assets should be balanced against that of liabilities; and both of these variables should be balanced against the Bank’s profitability goals. • The Asset and Liability Management Committee, ALCO has the responsibility for managing a bank’s assets and liabilities, to balance its liquidity and market risk exposures and thereby to help it achieve its operating objectives. • The challenge of ALCO is to assess the probability that these risks might materialize and to position the bank to be able to handle the most likelyscenarios with a minimum deterioration in performance and profitability

5. FUNDING DYNAMICS:PRINCIPLES,PARAMETERS, AND FUNDINGAPPROACH

6. Purpose • Outlines the key principles (or key lending guidelines) adopted • Broadly defines the key target market niches (TMN’s) that have been identified and adopted • Deliberates on selected development impact parameters (DIP’s), as well as their relative importance and their measurement • Suggests a funding approach • Rural Development Strategy

7. Key lending guidelines • Impediments that have faced Land Bank, in implementing its development mandate to date, include the following: • the focus on security-based “balance sheet” financing • the lack of appropriate lending guidelines for its products • Going forward, it is envisaged that Land Bank will increasingly utilize limited recourse finance in attempting to address the financial market failure that currently exists in the agricultural sector.

8. Key lending guidelines • Devcom has identified 3 key lending guidelines to govern all future land bank funding approvals: • Sustainability • There should be a clear ability of each applicant to service the funding provided by Land Bank. It is envisaged that Land Bank’s operational capacity will be enhanced to the extent that it will be able to conduct a multi-disciplinary (production, market, management, financial and legal) due diligence review of each application, in order for Land Bank to be able to determine such servicing ability • The following key elements should be confirmed by a party independent of the applicant: • Availability of resources – each application must demonstrate access to natural resources, such as the land, soil, climatic and/or water resources required by the envisaged enterprise(s). In the case of land, access needs to be demonstrated by a legal right, such as a signed offer to sell or a permission to occupy certificate. • In addition, each application must demonstrate access to the institutional resources (such as climatic data, soil testing facilities and technical support) that are required for a sustainable and profitable enterprise.

9. Key lending guidelines • Management and ownership – management and/or owners must demonstrate a basic level of production know-how and financial understanding. • Institutional/organizational structure - There should be an appropriate institutional and/or organizational structure, which clearly differentiates between management and ownership roles. • Support structures - appropriate non-financial support structures need to be in place. • Market and marketing infrastructure – each application must have a readily identifiable market or access to an existing marketing infrastructure.

10. Key lending guidelines • Commercial orientation\viability • Each application should clearly demonstrate its commercial orientation and should have the following attributes: • Commercial nature – each application must have a commercial agricultural dimension, which would typically differentiate it from either a subsistence farming operation or a non-agricultural enterprise or a residential or lifestyle-driven motive. • Commercial viability – each application must demonstrate that it is commercially viable in its own right, when measured in terms of specific criteria, and should not be regularly dependent on other sources of income. • Profitability and cash flow considerations are, therefore, critical. The projected financial statements of each application will be carefully scrutinized in order to determine the overall viability of the enterprise, as well as to prevent any potential incidences of reckless lending.

11. Compliance with the bank’s risk appetite • There should be a fair to good chance that Land Bank will be able to recover its funding, particularly after the application of appropriate measures to mitigate some of the risks involved, such as insurance, non-financial services and the way in which the application is structured. • Each application will typically be assessed in terms of inter alia one or more of the following financial parameters: • Debt to equity ratio • Cash flow cover ratio • Income security ratio • Profitability • The principle of sensitivity analysis of key variables (such as turnover) would also be employed to assess the robustness of each application in relation to the abovementioned financial parameters.

12. Target niche markets • In order that Land Bank is better able to meet its development mandate, several key target niche markets (TMN’s) have been identified and defined. • The identified TMN’s, which also incorporate the traditional “development” clients in Land Bank’s existing loan book, represent a much broader definition of development clients, the generic term for which is referred to in this document as the “emerging entrepreneur”. • This definition of the emerging entrepreneur includes all of the following individuals or groups: • Emerging HDP farmers • Emerging HDP entities, such as companies and/or trusts • Existing HDP communities that wish to engage in agricultural and/or rural development enterprises, projects or initiatives. • The targeted focus on these specific TMN’s will enable Land Bank to be more effective at addressing the financial market failure that exists in the agricultural space in Southern Africa. • TMN’s that Land Bank are expected to focus on, in the short and medium term, would also inform the KPA’s in Land Bank’s corporate plan. Identified TMN’s are expected to include the following:

13. Target niche markets • Indirect funding of emerging entrepreneurs via direct funding of large corporate clients, including inter alia existing co-operatives and other similar wholesaling clients. This target market will inter alia utilize an indirect/wholesaling funding mechanism to support emerging entrepreneurs, such as a cash credit account facility (CCA). In particular, increases in funding of existing corporate clients could be partially ring-fenced or reserved for specific development foci, such as emerging entrepreneurs • Indirect funding of emerging entrepreneurs via the direct funding of newly established co-operatives as well as via existing commercial infrastructure, in order to support emerging entrepreneurs in specific sub-sectors where marketing risks can be mitigated by off-take agreements or contracts, as well as via the application of a core unit/outgrower model (eg a sugar mill with HDP contract growers) • Direct funding of emerging entrepreneurs, via a revised set of lending criteria (such as softer security/collateral parameters) that would be partially determined by the sources of funding available for this sub-sector.

14. Target niche markets • Direct funding of emerging entrepreneurs, particularly groups such as trusts and communities, via the funding of inter alia enterprises that utilize land now available under the national land reform initiative, as well as those that can make a substantial contribution to food security. Such funding could involve inter alia partial risk and profit sharing by Land Bank, in the form of ordinary and/or preference shares and/or mezzanine funding and/or the provision of debt instruments. Land Bank would typically divest its equity holding over time, in favour of emerging entrepreneurs • Direct funding of the participation by emerging entrepreneurs in commercial primary or secondary agriculture (such as food processing) • Direct funding of the acquisition by emerging entrepreneurs of shares in existing and/or expanding enterprises, in order to inter alia promote national procurement policy • Direct funding and/or support of focused rural development enterprises or initiatives involving communities and/or groups, particularly those promoting the participation of women and/or youth and/or the disabled (WYD). • Direct funding of non-HDP commercial farmers and/or entities.

15. Development impact parameters • The DIP’s that will be considered by Land Bank in assessing the development impact of each application for finance from Land Bank

16. Proposed Funding model to support development • Specialist funding sources are expected to be utilized to support products aimed at the target niche markets. • The proposed funding model (refer also to the Funding Model to Support Developmental Lending) identified various sources of funding that could enable the bank to play a key role in meeting its development mandate in financing of the agricultural sector. • Land Bank is expected to make use of the following sources of funding: • Equity (from the shareholder) • Financial market funding, via the sale of Land Bank bonds/paper • Multilateral development finance institutions (MDFI’s) • Syndicates and/or special arrangements with commercial banks and/or other development finance institutions (DFI’s) • Focussed use of dividend income generated by the Land Bank Insurance Company (LBIC) • Grant funding, typically from the Departments of Agriculture and/or Land Affairs • Each funding source will be used, where appropriate, to support a range of products that will be developed for each target development niche markets, should they qualify. • Appropriate funding instruments, such as senior debt, junior/mezzanine debt, equity and funding of capacity building, are also expected to be applied. This approach will enable Land Bank to secure funding from funders whose mandate and/or funding focus aims at very specific target niche markets.

17. Next steps • Fundsubcom is expected to progressively focus on the following key aspects: • Prioritization of the target niche markets • An assessment of the availability of funds from various funding sources. • The development of an application appraisal methodology that is able to measure the development impact of each application for finance received. • The development of appropriate funding instruments.

18. Proposed Funding model to support development

19. SUPPORTING FINANCING INSTRUMENTS

20. Impediments to financing emerging farmers • The Development Committee has identified some of the critical issues that have impeded the financing of the emerging farmers in the agricultural sector. The issues are as follows: • Gearing effect on sustainability and viability of a farming enterprise - Many emerging farmers have limited cash resources to put as deposit in order to reduce the level of gearing which when is high, imposes high debt service burden and lead to a high probability of failure of the project particularly when the productive capacity of the land is limited relative to the high costs of acquiring agricultural land and input costs. The NCA also prevent financial institutions to finance farming projects were net asset value is high but productive value is low • The lag in loan service related to projects which take years to generate cash flows to repay loans - Some farming projects like the timber, fruit production and other sectors of similar nature projects require that farmers first plant the trees which then take long to be ready for production, leading into the inability of the farmer to service the debt costs within a year of having incurred a loan for this purpose. The Land Bank does not currently have products which enable these type farmers to only repay their debt when the trees begin to bear fruits. For example, in case of timber, it takes seven years and more for trees to have developed to a stage on which they can be sold and generate cash flow, while in case of fruit production it takes a minimum of about three years for tress to develop to a level where they can produce harvest

21. Impediments to financing emerging farmers • Limited Insurance products available to cover full risk - In case of insurance, the Land Bank insurance company has products which only cover 70% of the risk. This means that there is 30% which is not covered, and the financing institutions have 30% of open exposure which in case of the occurrence of the trigger event has to be absorbed in the balance sheet. This leads to the deterioration of the balance sheet of the institutions like the Land Bank depending on the degree and level of capitalization as well as the level of profitability

22. Proposed solutions • Equity Investments and Grants • To reduce the high gearing effect on the emerging farmer’s ability to service their debt it is recommended that the bank consult with the National Treasury and the DOA with the objective to propose that the government consider the following: • The Bank should also be allowed to develop equity instruments and use them to invest is some of these projects. The benefits are that the debt service costs will be reduced as equity investments by the bank will reduce the level of debt, and its costs service burden. This means that the sustainability and commercial viability of the project is improved. The Bank will then sell equity to the owners at a nominal price when the Bank has archived its expected/required return on the instrument (e.g. 5% real after Tax IRR) • The DOA and DLA should also be requested to provide the bank with cash to be used as grants particularly in cases of the installation of infrastructure by the beneficiaries of the land reform projects, and beneficiaries should only borrow from the bank to finance production loans. The bank will develop criteria on which beneficiaries can qualify for grants for this purpose. For example, the criteria can say that in cases where the productive capacity of the land is high the grant component will be low, but high in case of low productive capacity

23. Land Partners Expertise Community Finance Equity & Gearing Production

24. Proposed solutions • Introduction of Grace Periods • For timber, fruit production and other sectors of similar nature, the bank should approach National Treasury and DOA to provide funding that will be set aside for financing of loans that require that beneficiaries should only start servicing their debt costs when production begins. This can be done by establishing a separate fund that service interest costs in full or in part, and require the beneficiaries to repay the fund (at concessionary rates were possible) when production begins with the objective of minimizing the burden of interest that is being capitalized when there was no payment made during the grace period (grace period implies interest capitalized and therefore compounds the gearing problem which can be negative if rates are not concessionary • Insurance Fund • The bank should approach the National Treasury and DOA to assist it with funds to set aside to cover the 30% exposure that is not covered by insurance. This fund will be tapped into by the Bank when the trigger events occur, but there should be a procedure that will be put in place so that either National Treasury or DOA has power to approve that the Bank should when the event occurs, tap into the fund finance the 30% shortfall. The other vehicle that can be established is that the Shareholder and the Land Bank agree that the bank will set aside a percentage of its profits for this purpose (this can be modeled along the lines of the arrangement that NT has with DBSA for the Development Fund). The other issue is for the Bank and shareholder to enter into negotiations on what is the appropriate vehicle that can be put in place to ensure that there is cheap and affordable insurance

25. Required interventions and instruments • To achieve some policy principles, several interventions will need to be embarked upon, including the following: • Products • The Bank will develop appropriate products to enable delivery of the targeted market niche in line with the requirements of the market segments. These products will be reviewed on annual basis • Non-financial services to support new farmers and the sector • The Bank will facilitate and promote provision of non-financial services to the agricultural sector. Aftercare services will form the major thrust of these interventions

26. Required interventions and instruments • Funding for development • The Bank will raise funds in accordance with the target market niches. The Bank will only lend in those target market niches that are properly funded. It will then review funding requirements on regular basis • Stakeholder alignment and partnerships: corporate and operational level • The Bank will have a two-tier approach to managing stakeholders and partners. At corporate tier level or strategic level; the Bank will be guided by its stakeholder mobilisation, engagement and management plan/programme. This will be a deliberate pro-active process of engaging stakeholders and partners. At operational tier level, the Bank will enter into formal memorandum of understanding (MOU) with those partners and stakeholders it enters into relationship with. The stakeholder management process will be revised every two years.

27. Required interventions and instruments • Financing of strategic interventions for transformation • The Bank will finance and facilitate implementation of transformative programmes of government through (AgriBEE, land reform and equity investments) within the Land Bank mandate • Role in the development of agriculture in the region (SADC) • The Bank shall strive to position itself through SADC and NEPAD institutions by identifying agricultural initiatives and determines its role either through financial services and non-financials services.

28. STAKEHOLDER ENGAGEMENT AND PARTNERSHIPS STRATEGIC FRAMEWORK

29. The framework

30. The partnerships programme • The core of the Land Bank Partnerships Programme will be informed by the Land Bank Stakeholder Mobilisation Framework. The Land Bank Partnerships Programme (LBPP) is a multi-faceted and multi-disciplinary process that seeks to mobilise partnerships based on the Development Policy and Strategic Framework

31. Partnerships identification process

32. THANK YOU