Optimal Banking Model for Success

Bank lending is the most common source of external finance for many SMEs and entrepreneurs, which are often heavily reliant on straight debt to fulfil their start-up, cash flow, and investment needs. SMEs; however, typically find themselves at a disadvantage with respect to large firms in accessing debt finance. In middle and low-income countries, funding gaps are often even more pronounced and among the main barriers to small business formalisation. Moreover, while a large share of SMEs do not have access to formal credit, long-term credit to sustain investment and innovation is even scarcer, which severely limits growth opportunities.

Small and medium-sized enterprises make a significant contribution to the socio-economic and political infrastructure of developed and developing countries. The ability of SMEs to develop, grow, sustain and strengthen themselves is heavily dependent on their capacity to access and manage finance.  The ability to access finance is  a  major factor affecting the growth and success of SMEs. Many businesses face a lot of challenges acquiring loans from banks, and SMEs are the most affected.

Many studies have documented that medium, small and micro enterprises often fail to implement the optimal level of investments. It would be natural to attribute the observed sub-optimality of investments to firm decision-makers’ attitudes toward risk. While there have been numerous micro-econometric studies on risk, there have been few that take a more formal approach and assess the banking business model contribution to the individual and systemic risk of banks.

For regulators and policymakers, this study shows that this banking model is not simply about increasing societal welfare but remains a viable and incentive compatible banking model. For the banks, the results in the study indicate that by adopting state contingent banking, they can make use of profitable opportunities which otherwise would seem too risky to undertake.

The purpose of this paper is to extend previous model building efforts and build a model that identifies the conditions under which each banking type could become more optimal than the other. The model, presented by Atif Saeed Chaudry, Saad Azmat, and Maryam Sohail, tries to show that the state contingent contract remains a viable, beneficial and profitable contract for certain type of borrowing while debt remains the profitable option for others.

A bank operating as a monopoly can choose one of the two banking models: state contingent banking or conventional banking. Conventional banking model is based on the concept of lending on a fixed rate of interest. The financial background is checked before lending to ensure repayment and the longer the borrower takes to pay; the more he has to pay. A state contingent bank, on the other hand, lends money to entrepreneurs and charges them a proportion on the return of their projects. These banks do not seize assets/returns from projects whose return is very low. Therefore, the profitability of the bank directly depends upon the returns from the projects.

This study found that state-contingent banking is more profitable where projects are riskier, and debt-based conventional banking is preferred for relatively lower risk projects. The model presented in this study also suggests that state-contingent banking would be the optimal choice in cases where there exist greater moral hazard concerns. The authors have tried to identify the informational and institutional environments where state contingent banking may become the more profitable banking model.

Reference

Chaudry, A.S., Azmat, S. And Sohail, M. (2018). State Contingent and Conventional Banking: The Optimal Banking Choice Model. Economic Modelling, 68(C), 167-177. doi:10.1016/j.econmod.2017.07.008

About the Author

Saad Azmat is Associate Professor and Associate Dean (Research) at the SDSB, LUMS. He teaches courses in corporate financial management, financial markets, and Islamic finance. His research interests include Islamic banking and finance and financial instruments used in Islamic capital markets. His work has been published in Pacific-Basin Finance Journal, Journal of Economic Behaviour and Organization, and Economic Modelling.

Email: saad.azmat@lums.edu.pk