While California's farmers watch the sky for rainfall, bankers in the state are busy reviewing their risk-management practices to prepare for any fallout from reduced water access.

California, currently in the fourth year of a drought, is feeling added pain this year because of record-low levels of snowpack in the Sierra Nevada, which historically melts in the spring and fills the state's reservoirs.

The agricultural industry is currently exempted from water-usage restrictions recently put in place by Gov. Jerry Brown. Still, banks are beginning to keep a close eye on borrowers in water-intensive industries to make sure they are prepared to weather the drought.

"Bankers are pragmatic folks and they've had their eye on this for a long time," said Curt Covington, senior vice president of agricultural finance at the Federal Agricultural Mortgage Corp., also known as Farmer Mac. "No one is panicking … but all bets are off if conditions don't improve in 2016."

California is a large crop producer, growing everything from almonds and walnuts to strawberries and grapes. The state produces nearly half of the fruits, nuts and vegetables grown in this country, according to the California Department of Food and Agriculture.

But the severe drought has been challenging for farmers, while leaving some banks, especially those heavily involved in ag lending, reviewing policies and procedures and working with borrowers to make sure they have enough water to sustain operations.

To be sure, not all farmers have been affected, as some areas of the state fare better than others. The number of past-due loans secured by farmland are "negligible," said a spokesman for the California Department of Business Oversight, which oversees the state's banking industry.

The drought hasn't "bitten that hard yet," said John Blanchfield, a principal at Agricultural Banking Advisory Services and former senior vice president at the American Bankers Association's Center for Agricultural and Rural Banking. Still, current conditions have brought to light dangers for industries, such as farming, in a state that is largely "water engineered," he said.

"The main source of repayment is the sale of crops grown," Blanchfield added. "If there's anything that curtails the ability of the farmer to raise a crop then that will lead to cash flow problems."

As a result, bankers need to keep an eye on borrowers' access to adequate water, which is handled through a process called water budgeting, industry observers said. Lenders should make sure that agricultural borrowers "have a sustainable, legally protected water supply to begin or continue the operation being financed," said Colleen Coyle, director of water services at Ponderosa Advisors.

A farmer's water supply can include access to water rights for irrigation, which can involve surface water diverted from rivers through ditches and canals, along with groundwater wells. Water rights in most states in the Western U.S. are allocated based on the "prior appropriation" system, meaning "first in time is first in right," Coyle said.

Water rights can be owned separately from land ownership, and can potentially be severed and sold from the land, Coyle said. Vast amounts of irrigation water are delivered through massive federal and state projects, taking water hundreds of miles from wetter areas such as the Sierra Nevada to farms and cities in the dryer southwestern parts of the state.

Prior appropriation — based on mining law dating back to the Gold Rush when water needed to be separate from land ownership — means that water rights with junior priorities may end up with reduced water supply — or none at all — in the event of severe conditions, Coyle said. Many big irrigation projects have curtailed or eliminated water distribution during the current drought.

Bankers need to understand what water rights are allocated to a farm and make sure they secure those rights as part of the collateral, Coyle said. Otherwise, a bank could end up with farmland — but no water rights — in cases of foreclosure.

"I'm concerned that there's considerable exposure to lenders because water rights haven't been consistently identified, evaluated, and secured as part of the underwriting process," Coyle said. "If banks aren't looking at this, then the drought is an excellent motivator to begin incorporating a review of water rights into their work. If the water for agricultural operations isn't sufficient or sustainable, then the value of the asset will erode."

More farmers are relying on groundwater as surface water for irrigation becomes scarcer, industry experts said. Farmers are drilling more wells — and drilling deeper — to hit water. There are limits, though, because water can become saltier and brackish further down, Covington said.

Pumping out extreme amounts of water has also caused the soil to settle, Blanchfield said.

Suncrest Bank in Visalia, Calif., is located in the San Joaquin Valley, which has been harder hit by the drought than some other areas. Roughly 22% of the $189 million-asset bank's loan book is secured by farm land, according to the Federal Deposit Insurance Corp.

The bank has always reviewed access to water as part of its underwriting, though management has put additional measures in place to determine if borrowers can sustain their operations, said Ciaran McMullan, Suncrest's president and chief executive.

Suncrest, during the third quarter, started requiring borrowers to meet debt-service coverage ratio tests, even with the added costs of drilling a new well. Borrowers must provide well and pump tests annually and show that there is at least an additional 200 feet of water accessible. The bank also has a drought committee that meets quarterly to receive updates from water engineers and hydrologists to determine what, if any, underwriting standards need adjusting.

The bank's borrowers should be fine right now, McMullan said, though a persistent drought that lasts several more years could create repayment issues for more farmers.

"At a general level, we're still lending and still doing business with agriculture and farming," McMullan said. "The key test is your access to water, and specifically your access to groundwater. No one has much surface water in the San Joaquin Valley."

Bank of Feather River in Yuba City, Calif., is more fortunate. The vast majority of its clients are in the Sacramento Valley, where water deliveries, while down, are faring better than the San Joaquin Valley, Chief Credit Officer Jeff Cryer wrote in a memo to the bank's board. Still, the lower level of snowpack and added pumping has affected water levels.

The $75 million-asset bank has "stepped up due diligence on farm land loans and crop-production loans regarding the source, cost, delivery style and quality of the water farmers are using to irrigate with," Cryer wrote.

California banks are likely prepared to deal with some potential losses, said Jeff Rigsby, president and chief executive of consulting firm CB Resource. Experienced ag lenders, sensitive to how weather-related issues can influence the industry, are prepared, he said.

The California Department of Business Oversight has found "no major issues" during its examinations, though a spokesman said the agency will "closely watch those banks that have a higher agricultural exposure."

The Office of the Comptroller of the Currency "expects some individual borrowers may be impacted" by the drought, a spokesman said, adding that "banks have processes in place to identify and mitigate risk." The OCC in recent years has worked with its banks on "ensuring sound capital planning that considers these types of stress scenarios to capital," the spokesman said.

The drought could cause problems beyond farming, prompting banks that do little agricultural lending to review their portfolios and practices. A weak agricultural industry could drive up unemployment in some communities, and could cost the state billions in an economic loss, Rigsby said.

Recently implemented water restrictions could hurt other industries, such as landscaping companies, industry experts said.

Farmers & Merchants Bank has reviewed its loan book to identify businesses, including some golf courses and a fabric dye house, that could be hurt by the drought, said Phil Bond, the Long Beach, Calif., bank's chief credit officer.

"This will remain a topic of discussion going forward," Bond said. Water requirements for a business will "be one of those items we look at for loan requests. You can't turn a blind eye to the potential impact it has on borrowers."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.