Signaling Credit Risk in Agriculture: Implications for Capital Structure Analysis

Article excerpt

Signaling is an important element in the lender-borrower relationship that influences the cost and availability of debt capital to agricultural borrowers. This paper analyzes the effects of signaling on farm capital structure in conjunction with the pecking order and trade-off theories. The aggregate estimation indicates that signaling does affect agricultural credit relationships through measures of past cash flow and profitability. High-quality borrowers achieve greater credit capacity by providing lenders with valid signals of their financial status, while adjusting toward target debt levels over time and following the pecking order relationship in the short run.

Key Words: farm businesses, pecking order theory, signaling theory, trade-off theory

JEL Classifications: G11, G32, Q14

Signaling is an important element in the lender-borrower relationship that directly in- fluences the cost and availability of debt capital to agricultural borrowers. It is based on the premise that lenders prefer to finance higher-quality borrowers with lower credit risk. In determining a borrower's credit capacity, lenders need information that allows them to accurately distinguish between high- and low-quality borrowers, thus minimizing adverse selection problems. High-quality bor- rowers strive to inform lenders of their status by sending credible, unambiguous, and mean- ingful signals. In contrast, low-quality bor- rowers are unable to send such signals. Although signaling is a generic strategy applicable to many types of relationships, the signaling instruments for financial relationships rely on measures of strong financial performance (e.g., high profitability and cash flow) that strengthen risk ratings made by financial institutions.

The sensitivity of farmers' credit capacity to various financial characteristics and risk management was conceptualized by Baker, empirically tested in several studies, and found to differ significantly among such factors as farmers' use of crop insurance, forward contracting, choice of lender, financing instrument, income variability, asset structure, enterprise mix, and degree of vertical coordination (Barry and Robison). These studies are consistent with the signaling paradigm to various degrees, although Baker's approach was motivated primarily by liquidity considerations, while more recent studies have emphasized agency relationships, asymmetric information, and incentive alignments between borrowers and lenders (Hart; Hubbard; Jensen and Meckling). The results of these studies underscore the importance of endogenizing credit capacity in the capital structure analysis of farm businesses (Barry and Ellinger). Signaling also interacts with other dimen- sions of capital structure theory. Past econo- metric studies have concluded, for example, that the pecking order and trade-off (target or partial adjustment) theories contribute signif- icantly and jointly to understanding the capital structure of corporate firms (Fama and French; Shyman-Sunder and Myers; Vogt). Barry, Bierlen, and Sotomayor (2000) observed that farm businesses may follow a pecking order in adjusting to changes in or deviations from long-run targets on capital structure. Myers (2003), who originated the pecking order theory in 1984, suggested that joint consideration of the pecking order and trade-off theories is insightful but may fall short of explaining innovations and advance- ments in corporate finance (e.g., convertible debt, options, and stock repurchases). Signaling strategies should be considered together with the joint effects of the pecking order and trade-off theories to more com- pletely reflect the capital structure effects. Joint consideration will combine the borrow- er's side of the financing transaction with the credit cost and capacity issues on the lender's side. The latter considers how the lender's evaluation of the borrower's credit capacity responds to changes in financial conditions, new investments, and other financial charac- teristics of farm businesses. …