ARGUMENTS IN FAVOR OF BANKS WITH MULTIPLE OBJECTIVES

Dnipropetrovsk State agrarian university

Demchuk N.I.

Looking back at the time when savings banks and cooperative banks first came into existence, it is easy to see why these types of banks were needed and why they were created as not strictly, or not exclusively, profit-maximizing institutions. This brief look at history may answer the question of why these types of banks might still be needed today, even though we need to be aware of the fact that the historical relevance of a certain argument does not imply that it is still relevant today.

Savings banks came into being at a time when modern banking was not widely spread. Even in Europe and North America banking was largely confined to urban areas. Banks served only a small fraction of the population, mainly established businesses, landowners with sufficient collateral, and a few other people from the wealthier classes who had the relevant connections and social ties to the existing banks and bankers. Moreover, at that time, deposit taking and payment services were not considered to be genuine banking business, but as services that would merely complement "the real business" of banks, which was trade credit and enterprise credit. Hence, large segments of the population did not have access to financial services. They were, to use a term that has gained considerable prominence in recent years, "financially excluded". A similar situation prevailed in almost all so-called "developing countries" only a few years ago, and is still prevalent in many of these countries. In the past few years, some government-owned and foreign-funded development finance institutions have tried to compensate for this lack of access by offering specialized lending facilities. However, many of the early attempts to overcome this pervasive access problem failed, because the development finance institutions were inefficient and ineffective. These institutions used strategies that neither allowed them to become financially sustainable nor enabled them to reach the intended clients in the first place. Thus, they could not offer their clients a permanent and reliable access to financial services . But this failure does not suggest that the basic idea of filling a gap in the supply of financial services left by the operations of the existing conventional banks in these countries was inappropriate in principle. For many years, a policy of so-called financial repression made it virtually impossible for the existing banks to establish lending to poor people and to the local microlevel, small, and even medium-sized firms as a profitable line of business . More recently, a small number of specialized microfinance institutions have emerged. They have succeeded in providing financial services to poor clients and other formerly excluded potential borrowers on a permanent basis and thus mitigate the access problem. Interestingly, most of these institutions are also in some sense nonprofit organisations; they are credit unions, nongovernment organizations (NGOs) and self-help organizations. Some of them are restructured state-owned banks or even private commercially oriented banks, which nevertheless have a clear social mandate and mission and in most cases also enjoy some form of public support .

There are many reasons why "conventional" banks did - and in some cases do - not serve the middle and lower classes. Certainly, there were sociopsychological reasons, such as social prejudices, stubbornness, and ignorance on the part of the established bankers. But what is more important is the fact that it was, and sometimes still is, not economically attractive for profit-oriented bankers to serve these difficult clients. They do not have sufficient collateral; the risk of lending to them is considered as too high; and transaction costs appear excessive, given the financial technologies available to "conventional" banks and bankers.

Moreover, if bankers were to follow prudent and sound banking practices, the high costs of lending would force bankers to request high interest rates . Indeed, if a bank has borrowers with a high probability of default, they force their bankers to request high risk premiums, which would result in even higher interest rates. But high interest rates also have negative effects for the lending banks. They lead to adverse selection and moral hazard. As a consequence of adverse selection and moral hazard, we observe credit rationing as an endogenous feature of markets such as the loan market, in which information is unevenly distributed and lenders have reasons to believe that they are less well informed than the potential borrowers .

It may be too radical and thus unrealistic to assume that people with low income and wealth, and who have no "suitable" credit history, are completely rationed out in credit markets. Rationing might occur in markets in which (only) profit-oriented economic agents operate as lenders. However, there have always been some economic agents who will lend to these people and who are prepared to do so, although at high rates. Two groups of economic agents are particularly notable here: money lenders and institutions created by people inspired by political and philanthropically considerations.

Money lenders can succeed in their lending business where banks would not even attempt to do business because they typically have very good information about potential borrowers, and because they can use means of enforcing loan repayment that others would not want to apply. However, these features of the so-called curb market - high information intensity and questionable means of enforcing repayments - are the reasons why entry into the informal credit market is difficult and competition is largely absent. This market structure makes it possible for lenders to abuse their market power and to request borrowers to pay even higher interest rates than those warranted by the difficult lending environment. Even a casual look at both past and present history proves that this is exactly what happens. Either there is exclusion, or there is exploitation, and possibly both. From a social and economic perspective, this is a very undesirable situation.

In such a situation, there is always a motive for some people, who are mainly inspired by political and/or philanthropic considerations, or some organizations with a similar orientation, to seek ways to change the situation of those exploited or excluded people.

Finding ways of combating poverty that has its roots in a lack of access to credit can be accomplished by creating institutions that pursue objectives other than just that of making a profit. They can be charitable institutions; NGOs; self-help institutions, the precursors of cooperative banks; institutions created by benevolent entrepreneurs; or public banks, which in many countries includes savings banks as a special group. This is the historical reason why savings banks, cooperative banks and other institutions of the types mentioned have indeed been created: to serve people who would otherwise not have access to finance, but without the incentive to "overcharge" their clients.

The common feature is that these institutions pursue a dual purpose; they are "dual bottom line institutions" . One objective, and also a standard of assessment, is the impact that they have on the lifes of their clients; the other is profitability. Ultimately and over the long term, impact and effectiveness are the overriding goals since this is for what these institutions have been founded while in the short to medium perspective, profitability is more important. The relative weights of the two objectives necessarily change over the course of time, and they must change when conditions change. The stronger the competitive challenge, the more weight needs to be attached to the financial objective that secures institutional survival and is a precondition for providing socially relevant services.

This consideration also applies to today's savings banks and cooperative banks. Ultimately, they are needed for political and social reasons, even though many of them have developed from their traditional retail banking roots of catering to the poorer social groups and providing a limited range of relatively simple financial services into full-service universal banks that appear to be indistinguishable from their "conventional", commercial-bank competitors. This appearance may indicate that they are truly indistinguishable from "conventional" banks, and if this were indeed the case, it would indicate that they have completely lost their former social roles.

But the appearance that they are just like any other bank may also be deceptive. Economic survival requires that dual bottom line institutions remain economically strong and attractive partners for their clients. Many of these clients now have vastly different financial needs than they did 15 0, or only 50, years ago. Moreover, these banks need to remain competitive in the changing market for financial services, which they can only do if they adopt the strategies and methods of modern professional banking. The critical question is not whether dual bottom line institutions look like modern banks or whether they have added new services and new client groups to those offered and served many years ago, but whether they no longer provide financial services to those who would otherwise find the access to finance difficult, if not outright impossible. Only in the latter case would the ethical and political rationale for having this type of institutions discussed here no longer be valid and other arguments would be needed to show that these financial institutions were still necessary.

Dual bottom line institutions are also regarded as socially valuable because, they generate private benefits for their owners and also for others. In other words, they might, and in fact should, try to induce positive external effects. Economic theory recognizes that external effects or other sources of market failure can lead to equilibria in markets composed of profit-maximizing firms and utility-maximizing consumers that do not constitute a social welfare optimum. If equilibrium and social optimum do not coincide, then there is, at least in principle, the possibility of achieving welfare gains through appropriate forms of intervention in the market. Thus, the role of organizations that are not exclusively profit-oriented can be seen as improving social welfare by compensating market failures that are due to external effects or other reasons. Still another role can be to compensate market outcomes that are perceived as unfair and inequitable, by shifting income and economic opportunities to those who would be disadvantaged in a pure market economy.

The argument concerning positive external effects applies in principle to (other) public banks as defined above, and to savings banks as well as to all other dual bottom line institutions that aspire to improve economic efficiency and social justice, and it provides a slightly different argument for their existence than the standard argument that they counteract financial exclusion: Their activities are socially valuable if they allow certain transactions to occur which are not favorable for one or both private parties who might be involved in these transactions if they took into account only their own costs and benefits while the total economic benefits of these transactions would outweigh their total economic costs.

Relevant questions and some tentative answers. The two main traditional arguments, avoiding exclusion and enabling socially valuable transactions, apply in principle to savings banks. However, in a market economy, most economic activity is organized in the form of private and for-profit firms. As noted above, savings banks are neither fully private nor strictly or exclusively profit-oriented in all countries. Therefore, demonstrating that it is economically favorable to have this type of bank presupposes having answers to four questions:

(1) Is exclusion or the lack of access to financial services less of a problem in those European countries in which savings bank systems still exists than it is in other countries? And would it be more of a problem if dual bottom line institutions suddenly disappeared or changed their legal and institutional status and their objectives and truly became like any "conventional" bank? The World Bank has recently summarized the state of knowledge concerning financial exclusion, and it finds that access to the financial sector is also a problem in some advanced industrialized countries and that, over time, this problem might even become more acute . Data collected in Europe suggests that financial exclusion is a more severe problem in countries such as Great Britain, where all financial institutions are more or less similar in terms of their institutional design and where savings banks do not exist any more, than in other countries in which dual bottom line institutions have a large market share . However, before we can draw politically relevant conclusions from these observations, we must have at least some indications that correlation also implies causality. So far, these indications are still lacking10.

(2) Do savings banks provide financial services that are socially valuable and that would not be provided by a banking sector that is exclusively comprised of purely profitoriented banks? All we can expect to find to support this claim would be that the supply of financial services by dual bottom line institutions differs in terms of its volume and quality. However, there are some indications that this is the case. For instance, it is a well known fact that savings and cooperative banks play a stronger role in the financing of small and medium-size enterprises (SMEs) and in supporting newly established businesses than do the private commercial banks11 . However, the mere fact that savings and cooperative banks lend more to SMEs than do private banks does not answer the question of what would happen if these institutions no longer existed in their present form. We would have to know how private banks would react to a demise of these banks, and whether they would fill the gap that might result. To assume that private banks would not react at all and that they would leave the gap completely unfilled would not be plausible. But it is equally hard to believe that they would react in such a way that a possible gap disappeared completely once it became visible.

(3) Even if savings banks could be said to perform valuable functions, are the benefits that they may produce more important than the costs that their existence would entail? To answer this question, we need to look at the costs and returns of different banking groups. Data for several European countries with sizable savings bank systems suggest that over a medium time perspective the costs of savings banks are not higher and even lower than those of other banks and the returns of savings banks are either higher, or at least not lower. Therefore, it appears that they can afford to provide socially valuable services without endangering their financial stability.

(4) The final, and possibly most difficult question is whether savings banks are better suited than other dual bottom line institutions to play the socially valuable role that we expect from dual bottom line institutions.

There cannot be a simple and general answer to this question. Too much depends on how the different types of dual bottom line institutions are designed as institutions, how they operate, and the structures of the financial and legal systems in which they operate. Of course, savings banks do have certain weaknesses as institutions13. But all other types of banks, including (other) public banks and cooperative banks, also have weaknesses as the current financial and economic crisis has so convincingly demonstrated. New arguments. Recent economic research concerning financial systems has led to a set of additional arguments in favour of savings banks and other types of banks that are not purely profitoriented and that do not have owners with the unrestricted property rights that the owners a private bank have. I present three of these arguments here.

A) strengthening cooperation between savings banks. Focusing on lending to local clients has always been a defining characteristic of savings banks. In all countries that still have, or have formerly had, savings banks as an important element of their national financial system, this local orientation has been enshrined, more or less explicitly, in the relevant laws and regulations. The term for this focus is "the regional principle". Originally, this principle was devised because savings banks were locally rooted and therefore were assumed to have a specific informational advantage in lending to local clients and a comparative disadvantage in lending at a greater distance. By being cautious lenders who use available local knowledge, savings banks also safeguard of their clients.

The role of savings banks in fostering local and regional economic development by preventing a "capital drain" has already briefly been discussed above, since it is by no means a new argument. However, there is an additional aspect of the local orientation that needs to be taken up at this point. One reason for imposing the regional principle was, and in many countries still is, that it limits the competition between the different savings banks, but does so without violating the relevant competition laws. Not being competitors in their lending operations is important, in my view, because it implies that the different savings banks that exist in a larger region, or even in an entire national economy, have good reasons to regard each other more as colleagues than as rivals, and this in turn is a prerequisite for being able and willing to co-operate in a number of other respects, and this, once more in turn, may be a reason for the success of savings banks in financial or pure business terms. The logical link between the regional principle and business success needs to be explained at greater length. Generally speaking, the optimal size of a banking outfit is difficult to determine, and it differs depending on which function we look at. We can assume that the optimal bank size is not the same for all operations that make up a bank, i.e., it is different for different elements of the value chain of a bank. For some functions, a smaller size is sufficient and even optimal, as is the case with most of those functions that are close to the interface with clients. For other functions, where economies of scale can be assumed to exist, larger sizes may be more appropriate. Therefore, savings banks can achieve greater success in business if they can cooperate with each other in the latter group of functions and benefit from the economies of scale that this cooperation generates. Examples of fields in which local savings banks can benefit from close co-operation are data processing, training, or public relations; certain aspects of risk management; and political lobbying. If savings banks have reasons to regard each other more as colleagues than as competitors, then the individual savings banks are more likely to fully cooperate in performing these functions by, e.g., setting up common data processing facilities, common training facilities, and common guarantee systems, and by fully supporting their associations, than they would be if they were essentially rivals. By doing so, they can cut costs and improve efficiency. This economic benefit arising from cooperation is exactly what we can observe in those countries in which the regional principle is still in force. At least for these cases the regional principle in its "systemic" role of being the institutional basis for co-operation is part of the overall business model of the savings banks. Thus, the regional principle substantiates the importance of one characteristic feature of the savings banks in some countries, namely that they are part of decentralized networks that combine the advantages of having relatively small decentralized units as its core elements with the advantages of achieving economies of scale in certain functions where these economies may be substantial.

B) mitigating intertemporal risk. In any advanced economy, there is a certain degree of competition between capital markets and banks as financial intermediaries. Both have their specific roles, strengths and weaknesses, and both have an important role in risk management, with each one of them specializing in managing one specific form of risk. Capital markets are particularly good at managing the risk that materializes in one specific time period, since they have a competitive advantage over banks in providing opportunities for investors to reduce risk by diversifying their shareholdings. Moreover, capital markets are particularly good at permitting risk sharing and the efficient allocation of those risks that are not eliminated through diversification. However, diversification and risk-sharing are methods that cannot cope with all kinds of risk. The type of risks that capital markets are so good at handling is risk within a given time period, which is also called intratemporal risk.

There is also another form of risk, namely the risk that over time, the income for the entire economy varies in an unpredicted way. This kind of risk is called "intertemporal risk", and it cannot be eliminated through diversification. Technically speaking, it is the systematic and macroeconomic risk of good times being followed by bad times. Clearly, intertemporal risk is an important kind of risk, and reducing it is a socially valuable function, since the people that make up an economy want to be protected against this risk.

Capital markets are in a certain sense short-sighted, and therefore unable to deal with intertemporal risk. In contrast, banks are in principle able to handle intertemporal risk, because they can create reserves in good times and reduce these reserves in bad times, provided that they wish to do so. Creating and unlocking reserves is a specific technique of risk-management that closely resembles the role of storage in a primitive farming society. If there is a bumper harvest in one year, a large part of the harvest is stored, and if the next year's harvest turns out to be poor, the stored reserves can be taken out and consumed. Intertemporal risk is thereby reduced, income is "smoothed", and utility increases. It is intuitive, and can be proven in a relatively simple economic model, that risk-averse people value this "storage option" highly. This implies that having banks that can and want to create reserves in good times and unlock them in bad times would be socially valuable. However, it is important to understand that being able to mitigate intertemporal risk is not the same as having the incentive to do it and wanting to do it.

Unlocking reserves can take two forms. One is the isolated or direct sale of previously created reserves. The other is the sale of the entire bank at a price that includes the value of the reserves. If regulation makes the direct sale impossible, the bank can choose the second alternative. However, there is a conflict between what is optimal for the entire economy and what is optimal for the individual bank and its (private) owners. For an individual bank, disclosing and selling its reserves in good times is always more profitable than keeping them. Therefore, strictly profit-oriented bank owners or bank managers who act exclusively in the financial interest of a bank's private owners will choose to disclose and sell the reserves. And even if the managers would prefer not to act this way, the stock market pressure would force them to do so. Thus, such pressures would expose the economy to higher intertemporal risk and cause severe social damage.

The next step of the argument is straightforward. It would be socially valuable if bank managers and owners were not interested in disclosing and selling the reserves they might have built up, or that it would not be possible for them to act in this way. This is the case with savings banks, (other) public banks and cooperative banks, since by design and mission they are not strictly profit oriented, and since, because of their institutional and legal design, they cannot be sold at their full value. Thus, their managers can be expected to create reserves in good times and unlock them if there is a need to do so. Neither earnings pressure nor stock market pressure prevents them from performing the socially valuable function of reducing intertemporal risk.

This argument has been developed by the economists Franklin Allen and Douglas Gale16. It is a powerful and theoretically sophisticated argument for having banks that are not strictly profit-oriented and whose ownership position cannot be sold. These banks include public banks and banks owned by foundations or other owners that would not consider selling the banks - thus different forms of savings banks - as well as to a certain extent co-operative banks.

C) capitalizing on the value of diversity. The third new argument in favour of having savings banks also rests on recent developments in economic theory but also corresponds to what non-economists would regard as plausible. This argument relates to competition. Competition is much more complicated than standard accounts of introductory economics textbooks that rely only on established microeconomic theory might suggest. According to a view that goes back to the Austrian economist Joseph Schumpeter, competition is a process that is driven to a large extent by knowledge that exists, and by newly created and discovered knowledge and innovation. For competition to work, new ideas must be generated. But this is not enough. It must also be possible to transform these ideas into economic reality: invention must be translated into innovation. Financial systems develop over time. New instruments and new institutional forms are created that may turn out to be more or less successful. As a matter of principle, it is impossible to predict what will be successful financial instruments and institutions in the future. A process of creative and dynamic competition must be based on openness. This insight argues for diversity. Diversity offers an optimal basis for new ideas to emerge and for old ideas to make a come-back.

For banking systems, openness and diversity imply that different institutional forms should exist and should be made sufficiently strong so that they have a fair chance of emerging successfully from the competitive struggle. One such form is that of a savings bank or, to be more precise, a number of such forms are the different institutional designs that jointly make up the universe of savings banks. In the past, savings banks have demonstrated their ability to compete with other institutional forms of banking, to adjust to new circumstances, to create and utilize new ideas, new products, and new processes, and to survive in environments that are more and more shaped by fierce competition. Hence, they are as valuable as other institutional forms of banking. All of these institutional forms should have their chance to develop and to display their respective strengths. The economic arguments that suggest that one specific form of organizing banking activity, namely that of the large private bank with many shareholders, is the best one, may appear plausible, but they are not conclusive17. We do not know enough about the merits and the potential of different forms of enterprise, especially in banking, to be able to assign a clear priority to one specific model and thus obstruct the development of others.

There may be substantial benefits to having these hybrid forms. Just like cooperative banks, savings banks are a part of this tradition of diversity and openness. This is an important argument in its own right for having savings banks. Neither the request of central governments to expand their powers nor an overly simplistic model of a market economy should be used to undermine this tradition and force savings banks into adopting one of the polar forms of a state bank or a "normal" private firm.