A firm-level model for commercial banks servicing agriculture: A multi-stage stochastic programming approach

Rural commercial banks are facing many challenges as they transition into the next century. There are considerable uncertainties about commercial banks' long-term access to cost-effective sources of funds. The changes in the sources and costs of loanable funds coupled with the changes in sources and levels of demand will likely increase bank's exposure to interest rate and liquidity risks. The ability of banks to manage these risks and uncertainties in an efficient manner will play a large role in determining the survivability and competitiveness of commercial banks in agricultural financial markets. These risks and uncertainties have motivated the American Bankers Association and the Independent Bankers Association to seek new authorities to access alternative sources of loanable funds.;The objective of this study is to create a methodological framework to evaluate the performance changes that are occurring with commercial banks through funding alternatives. Two methodological frameworks are incorporated: (1) an optimization model to determine the optimal investment and financing activities the bank should pursue and (2) a simulation model to project interest rates. The optimization model is a multistage stochastic programming model that is employed to estimate performance effects on liquidity, profitability, risk tolerance and growth. The simulation model for estimating stochastic interest rates is based on a mean reverting Ornstein Uhlenbeck process. The specific procedures of the interest rate simulation model are done following Evans, Keef, and Okunev (1994). The bank performance changes are evaluated under different economic scenarios. Scenarios include varying: interest rate risk tolerance levels, interest rate environments, loan demand volatilities, and deposit flow trends. Representative banks at two different loan to deposit ratios are examined. Two levels of collateral utilization rates are also used to examine the effects of alternative funding.;The model results depend upon the model specification as well as the linkage between the bank and its external environments. In general, the differences between the balance sheet decisions made by the bank under the alternative scenarios are not large. Major findings of this study are (1) profitability is not substantially affected by alternative funds; (2) alternative funds aid interest rate risk management; (3) alternative funding is advantageous when deposit funds are declining; (4) alternative funds are needed to expand loan volume in periods of high loan demand; (5) expansion of the collateral base may not be needed; (6) loan demand, policy constraints, and gap ratios are often constraining the level of alternative funds used; and (7) arbitraging may occur in banks' investment portfolio as additional funding is used.