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State contingent and conventional banking: The optimal banking choice model

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  • Chaudry, Atif Saeed
  • Azmat, Saad
  • Sohail, Maryam

Abstract

This paper compares and contrasts the optimality of debt based banking and state contingent banking. We show that the advantage each of these banking types holds over the other might not be universal; rather it may be an outcome of the informational and institutional environment in which they operate. In our model, banks optimize both the riskiness of the project and moral hazard concerns to identify the most profitable banking model. We find that state contingent banking is more profitable where projects are riskier, and debt abased conventional banking is adopted for relatively lower risk projects. Our model also suggests that state contingent banking would be the optimal choice in cases where there exist greater moral hazard concerns. We explore the empirical implications of our model and find that state contingent banking would be more suitable for small firms, emerging markets, community and Islamic banking.

Suggested Citation

  • Chaudry, Atif Saeed & Azmat, Saad & Sohail, Maryam, 2018. "State contingent and conventional banking: The optimal banking choice model," Economic Modelling, Elsevier, vol. 68(C), pages 167-177.
    • Handle: RePEc:eee:ecmode:v:68:y:2018:i:c:p:167-177
    DOI: 10.1016/j.econmod.2017.07.008
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    References listed on IDEAS

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    Cited by:

    1. Chen, Naiwei & Liang, Hsin-Yu & Yu, Min-Teh, 2018. "Asset diversification and bank performance: Evidence from three Asian countries with a dual banking system," Pacific-Basin Finance Journal, Elsevier, vol. 52(C), pages 40-53.
    2. Khan, Abdullah & Rizvi, Syed Aun R. & Ali, Mohsin & Haroon, Omair, 2021. "A survey of Islamic finance research – Influences and influencers," Pacific-Basin Finance Journal, Elsevier, vol. 69(C).
    3. Azmat, Saad & Hassan, M. Kabir & Ghaffar, Hamza & Azad, A.S.M. Sohel, 2021. "State contingent banking and asset price bubbles: The case of Islamic banking industry," Global Finance Journal, Elsevier, vol. 50(C).
    4. Azad, A.S.M. Sohel & Azmat, Saad & Hayat, Aziz, 2023. "What determines the profitability of Islamic banks: Lending or fee?," International Review of Economics & Finance, Elsevier, vol. 86(C), pages 882-896.

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    More about this item

    Keywords

    State contingent banking; Conventional banking; Moral hazard; Islamic banking;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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