What Banks Really Look For When Lending to Farmers

Podcast transcript from Your Farm Business Podcast

When a bank says yes to a loan, does that make it a good decision? Not necessarily. In this episode of Your Farm Business Podcast, host Tom Moir sits down with Mike Krause, founder and CEO of P2PAgri, to pull back the curtain on how banks really think about lending to farmers, drawing on Mike's years inside a bank as an economist and decades since helping farmers put their numbers together before they sit down with a lender.

Mike explains what actually motivates a bank, the three things every lender weighs up before saying yes, why seasonal finance is priced differently from a land purchase, and the one grey area where a well-prepared farmer can genuinely move the needle on their interest rate. He also shares a sobering story about a farmer sitting at 17% equity, and two myths worth retiring for good.

Banking from the Inside: Mike's Background

Tom Moir:

Today we're talking about banking: the relationship between banks and farms, and especially the lending process. You've had a fair bit to do with this over the years, Mike. Can you share a bit of your background with banks and farms?

Mike Krause:

Sure, Tom. I'll say from the outset that I haven't been a lender in a bank, so I've never walked onto someone's farm to do a lending assessment. But early in my career I worked for four years as an economist for a bank in South Australia, so I related closely to the people who were lending to farmers, and I came to understand the processes they go through and what motivates a bank when it lends. After I left the bank I became a consultant to farmers, so when someone wants to buy the neighbour out or borrow more money, they come to me to help put their numbers together to take to the bank and secure the lending. So I've had a lot of experience working with different lenders and different farmers in that situation.

What Actually Motivates a Bank

Tom Moir:

In a general sense, what motivates a bank to lend to farmers when they come to approach them?

Mike Krause:

This is a really key question, Tom, because as farmers we tend to assume the bank has our best interests in its hands. So if the bank looks at our numbers and says, yes Tom, you can buy the neighbour, we'll lend you that $3 million, some farmers think, well, the bank reckons it's a good idea, so it must be. My advice is: don't let the banker be your final decision maker. You're the one agreeing to that $3 million loan, and it's your responsibility to pay it back, so you have to be sure it's a good decision for your business and that it helps you grow the business, the wealth and the profitability.

The bank's motivation is very different. A bank answers to its shareholders, so it has to make money bringing deposits in and lending money out. Think of a bank's business like a water pipe, where the water is money. They bring depositors' money in one end and lend it out the other, taking a small margin in between. The faster that water flows through the pipe, the more margin they make and the better their profit. So when a bank lends to a farmer, its motivation is to be sure you're a secure person to lend to and that the likelihood of being repaid is very high. Whether Tom is ultra profitable or just modestly profitable doesn't really matter to them. They just want to know they will get their money back over the long term.

The Three Things Every Bank Looks For

Tom Moir:

How does a bank juggle the opportunity and the risk when a farmer comes in and says, here's what I want to do? There's a lot of risk but also great opportunity. What are they looking for?

Mike Krause:

Good question, Tom. We sometimes think it's black and white, that they just pull Tom's numbers out of the computer and it says yes or no. But there are grey areas, and farmers should understand they can influence them. There are really three things a bank looks at when it lends to a farm.

The first is your balance sheet. They look at all the assets you own against your outstanding loans and ask, is there capacity here to secure the loan against an asset? If Tom owns land and wants to borrow $3 million, and the land is worth, say, $10 million, then they can mortgage against it, knowing that if all the wheels fall off they could sell the land and recover their $3 million. Security is number one. Banks will say they lend on cash flow, but if the security isn't there, they won't be that interested.

The second is your ability to repay, and that's why they focus so hard on your cash flow. If Tom borrows $3 million his repayments go up, so they'll add the new land, the new debt, the extra income and the extra costs, including any additional seasonal finance for fertiliser, seed and chemicals, and check it all works. Then they'll stress-test it: what happens in a drought, or if the season isn't as good? Can they still get their interest payments? Those first two are fairly black and white, you can't invent numbers there.

The third is the key one, where you get to present your business to the bank. If Tom turns up having done his balance sheet and his cash flow, he's already showing the bank he understands their risk in lending to him. On top of that he tells the bank what he plans to do with the new land, and where he wants to be in five years' time. So even with all the risk and uncertainty, interest rates, seasons and commodity prices we can't predict, Tom is demonstrating how he'll manage the business for his own profit and to make sure the bank gets repaid. The bank is quietly rating how good a manager Tom is, and if he presents himself well they gain confidence he'll do what he says and they rate the risk of lending to him at a better level. At that point they're really becoming a partner in your business.

Seasonal Finance vs Buying the Neighbour Out

Tom Moir:

Cash flow on the farm can be irregular and stacked toward one part of the year. How does a bank approach seasonal lending, compared with lending to buy more land? They feel like slightly different boats.

Mike Krause:

They are different boats, and the risk is different too. With seasonal finance the bank wants to know your cash flow so they know how much money to have available for Tom when his borrowing peaks. In a mixed farming operation that's usually late April into June and July, when everyone has maxed out their seasonal loans for fertiliser, seed and chemicals, and then they wait for harvest. That's less predictable, because Tom doesn't yet know if it will be a good, average or poor season, and if it turns wet with good subsoil moisture he might want more nitrogen and go back to extend his overdraft. His ability to pay it all back depends on the harvest, the wool cheque or the cattle sales, so that lending is riskier and they generally price it a bit higher, with more of a risk premium in the interest rate.

A $3 million land purchase is different. That's a fixed amount with set repayments, and since the Banking Royal Commission banks tend to write it as a 20 or 25-year loan with principal and interest paid together, so it's more predictable, and it's secured against the land anyway. More recently some banks have encouraged farmers into a line of credit, where the seasonal loan and the land loan sit in one facility and you pay a little back each year rather than clearing the overdraft to zero. If you're in one of those, just make sure you're on top of your financial management and recording, because it's a bit like being handed a big credit card, and it's very easy to max it out. That's not a situation you want to be in.

Common Mistakes: Don't Just Bank on Loyalty

Tom Moir:

Are there common mistakes farmers make when they approach a bank for finance, even in their mindset before they walk in?

Mike Krause:

One is the loyalty mindset. It's a bit like your accountant: once you've got a relationship with a bank it feels hard to leave. My father banked here, his father banked here, and even though I'm talking to a new branch manager every six months, the fees are creeping up and they don't really know my operation. The first bank you leave is always the hardest, but once you've done it you know it can be done. Some farmers make it a policy to keep the banks honest every five years: they put their business up and get a quote from bank A, B, C and D to see who comes back with the best deal. Remember the big four are competing, and a bank would rather keep Tom than lose him, because replacing him means spending on marketing and sales. So the last thing they want is to lose a client.

You can always take a better offer back to your existing bank and ask them to match it, which saves the hassle of switching. There's real power in the farmer's pocket if they choose to use it. But don't bluff. If you tell the bank you're going to shop around and then never do it, they'll decide Tom won't follow through, and they may edge your rate up because that's how they make their profit. Do your due diligence, and it goes a long way. I don't think it's that common in farming for people to do their due diligence as well as they should.

What to Put in Front of the Bank

Tom Moir:

When they do go to the bank, what documents help them actually get the loan over the line?

Mike Krause:

It wouldn't hurt to have a business plan, Tom. A business plan tells the bank why you're farming, your vision for the farm and how you'll achieve it, whether Tom is going to be the best cattle breeder in the district, the best merino breeder or the best crop producer, along with the strengths and weaknesses of the business. They'll definitely want to see updated cash flows. If you're preparing planned cash flows and then comparing them against your actuals, that shows very clearly that you stay on top of your business as seasons and markets shift. And give them an updated balance sheet: where your land, machinery and livestock values sit, and where your current lending sits.

When they do a review they can then see clearly that you're on a path to success and monitoring it, which gives them confidence you're in control and that they're a partner helping you get there. If you're really keen, do some of the ratios they look at, like the percentage of variable costs against your gross income, or your interest cover. That's high-level management, and it puts you near the top of the tree of people they want to lend to.

The Real Cost of "Set and Forget"

Tom Moir:

Do a lot of farmers just set and forget? They get the initial loan and the overdraft, keep it steady year on year, and leave it. What would you say to them, are they missing out on something better?

Mike Krause:

They are. Off the top of my head there's about a 2% swing in the interest a farmer pays, and a lot of that comes back to how the bank rates you as a manager and how you manage their risk. If you keep on top of that, you'll do well. Set and forget is one of the worst things you can do, because these banks are here to make a profit, and if they can charge you a little extra interest, what's to stop them?

Banks are also quite conservative. A client once asked me to come and look at their financial situation, and when I added up the numbers their equity had dropped to 17%. Banks like to see you at 60 or 70% or above, so I was almost looking over my shoulder for the bank manager coming to take the keys. I rang the bank and said, I know these people aren't travelling well, but do you know how bad it is? And they said, yes, we've got them in the non-performing loans section, they're at 17% equity, but we know once they sell up we'll get all our money back. What the farmer didn't appreciate is that land values only had to fall 10% and he'd have no equity left in the farm. The bank would get its money back, but he'd walk away with almost nothing. If you set and forget and stop monitoring your financial performance, you can slide into a deep hole, miss repayments, watch the interest compound, and end up losing the keys. That's the worst case, but I have seen it happen.

Carbon Farming, Green Loans and AI

Tom Moir:

How do banks treat trending things, fluctuating commodity prices, carbon farming, the arrival of AI and technology, when it comes to lending?

Mike Krause:

If you're adopting technology and using it efficiently to improve your performance, that can only augur well for you as a borrower. It shows the bank you're on top of your management game and improving your security of repaying their loan. There have been trends like green loans, where you're rewarded for doing the right thing on carbon, but sometimes those are a bit of a fad that come and go. They only really stick if they're embedded in the industry, for example if government required you to report and improve your carbon rate or face penalties, and that hasn't happened in Australia. And because banks are competitive, a green loan at one bank doesn't stop you asking another to match it.

AI is a huge moving target right now. Two weeks ago I'd have said banks are starting to use AI to crunch the numbers and give them more confidence before they lend. But now they're building agents, so it's like two AI systems talking to each other and running combined processes. We might be only a year away from ringing a bank and not knowing whether you're talking to your branch manager or an AI bot gathering information from you. For 20 years the banks' biggest cost has been staff, so if AI can do what employees did at half the price, guess which way they'll go. The fundamentals we've talked about in this episode won't change, though. As a farmer you're fairly protected from being gobbled up by AI, because people still have to eat bread and tomatoes and drink milk, and AI can't produce that overnight. But the people you deal with, banks, accountants and advisers, will keep using it.

Getting Bank Ready: Build the Skills Yourself

Tom Moir:

Given everything we've covered, what advice would you give a farmer who wants to be bank ready and approach the bank with confidence?

Mike Krause:

Like we said, go to the bank with your business plan, your cash flow and your balance sheet done, so you know your finances and can even discuss how the risks to the bank might have changed. That's really high-level management. If you're not up to that speed yet, educate yourself. We've created an online course through Tocal Ag College in the Hunter Valley that helps farmers improve their financial literacy and build cash flows, balance sheets and business plans, all done with cloud-based software over Zoom or Teams, so you never have to leave your office.

Farmers can also use consultants to get up to speed, but I'll say this: when a bank lends to Tom, they want to know Tom has these skills, not just his consultant, because it's Tom who repays the $3 million, not the consultant. So there still has to be an element of business acumen that the farmer owns. If you don't have it, go and find it, whether through that course or another opportunity.

Two Myths Worth Retiring

Tom Moir:

Before we wrap up, are there any common myths you'd like to debunk, things you hear that make you shake your head?

Mike Krause:

There are a couple. The first I mentioned earlier: if the bank says yes Tom, you can borrow that $3 million, don't assume that because the bank said yes it must be a good decision. Sit back, be the master of your own business, and work out whether that $3 million is going to make money for you and not just for the bank. Make sure it's genuinely profitable and that you're not putting yourself in a position where a poor season means you can't meet the repayments and you dig a deeper hole. It's your legal commitment to repay, not the bank's, so you have to be in control of the decision.

The second myth is that you're shackled to your bank. You're not, you can change banks, but it's far easier to switch when you're in a financially strong position than a weak one, so take that opportunity when it arises.

Tom Moir:

You mentioned the online course. Where can people go to find out more?

Mike Krause:

Jump into your browser and search for "Plan to Profit Tocal", and that'll take you to a page where you can see how the course runs and what you'll learn. Or come directly to us at P2PAgri, just Google us, and you'll find our contact details. We train farmers right around Australia one-on-one and bespoke, so we can meet you at whatever level of learning you're at. If you come to us directly we tailor the learning to your work requirements and other responsibilities. Tocal is a bit more structured, on a fortnightly rhythm with homework that keeps you honest, and we've run it through seeding and harvest and still get great completion rates. Farmers tell us they'd rather learn that way than the old way of heading to the CWA hall, and they walk away having learned exactly what they hoped to.

Tom Moir:

Any closing comments before we wrap up?

Mike Krause:

Treat the bank as your friend, not your enemy. They're a partner, so keep your communication open and free with them, and yes, you'll have to live with them changing managers fairly often, but that doesn't mean you stop communicating. We need lending to grow our businesses, and there's good lending and bad lending. I'd really encourage you to keep using the good kind.

Tom Moir:

This episode has been all about the lending process and the relationship between farmers and their banks. Next episode ties in closely, because we'll be talking about tax and the accountant, another area you've got plenty of history in.

Mike Krause:

I'm familiar with that one, Tom. I want to talk about what really motivates your accountant and how to get the most out of them, a bit like what we've just done with what motivates your banker and how to get the most out of your bank. Catch you soon.