Farm debt and the over-exploitation of natural capital

This paper uses a stochastic optimal control model to show how standard loan contracts create incentives for farmers to focus on short-term financial performance at the expense of farms’ long-term natural capital. These incentives are a manifestation of the debt overhang problem. Extending this model shows how sustainability-linked loans can be used to weaken these incentives in a way that potentially benefits farmers and their bankers. The magnitude of the economic benefits generated by these loans depends on farm characteristics. The paper investigates the optimal design of sustainability-linked loans.