7. Conclusion
This paper compares state contingent banking with conventional debt based banking. We show the neither form of banking is universally superior to the other; rather their optimality depends on the riskiness of the underlying projects and moral hazard concerns. We find that state contingent banking is more profitable where projects are riskier, and debt based 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. In our model, banks optimize both the riskiness of the project and moral hazard concerns to identify the most profitable banking model. 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. While the previous literature had identified issues related to the externality of debt and proposed state contingent banking as a more welfare enhancing alternative, the viability and profitability of this form of banking was largely ignored. We have tried to fill this gap by identifying the informational and institutional environments where state contingent banking may become the more profitable banking model. Our findings should help regulators, policy makers and banks to better implement state contingent banking. For regulators and policy makers, our paper has shown that this banking model is not simply about increasing societal welfare but remains a viable and incentive compatible banking model. For the banks, our results indicate that by adopting state contingent banking, they can make use of profitable opportunities which otherwise would seem too risky to undertake.
