State contingent and conventional banking: The optimal banking choice model

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.