Rediscovering the Role of Banks in Business Financing: From Mere Lender to Business Partner

SEP-OCT 2017|BY DR. STEFANOS ZARKOS, ASSOCIATE PROFESSOR IN THE PRACTICE OF FINANCE, ACADEMIC DIRECTOR OF THE MSC PROGRAMS*, ALBA GRADUATE BUSINESS SCHOOL AT THE AMERICAN COLLEGE OF GREECE
Despite their bad rep in recent years, banks can be key allies for fledgling ventures and established businesses alike.

If I were asked to explain what the role of banks in business is, I would refer to three basic lessons provided by finance theory:

Lesson 1: The role of banks in capital markets

Given a choice to either borrow or save along with their investment in equity (efficient market portfolio), investors are able to achieve investment combinations that best match their personal risk preference. Borrowing allows investors to leverage their investment to a higher level of expected return, but with higher risk exposure. Saving, which leads to deleveraging, offers lower risk, but also lower return, investment options.

Lesson 2: Banks as risk
transformers

Think of electrical transformers that take high voltage and convert it to a lower one. Similarly, banks, while offering depositors the highest possible collateral, accept a much higher risk of default from borrowers (businesses and households). This risk difference highlights the need for effective risk management; lack of such could cause the transformer—electrical or risk—to melt down. Yet while banks take a number of steps to secure the loans they provide, credit risk can never be completely eliminated, as it will always cause some damage due to credit default.

The recent crisis, and its negative effects, reminded us that banks play a much more important role than just selling loans. Overwhelmed by banks’ aggressive efforts to sell credit during the pre-crisis period, people almost forgot their true role and their contribution to economic development, accusing them instead of underutilizing society’s resources, promoting the interests of executives, and destroying value. For some, this is just how banks work, and nothing can be done to change it. Allow me to disagree.

Lesson 3: There are no perfect guarantees

Empirical evidence and real life experience have shown that no loan guarantees provide full protection against credit risk. The crucial question for banks is how to prevent credit default from occurring in the first place, rather than what compensation to seek after the fact. Case in point, in the systemic crisis we have experienced, traditional protections in the form of collateral or other guarantees proved to be almost totally ineffective.

What is the takeaway from these lessons? The best protection against default risk is for banks to lend to firms that have the potential for business sustainability, growth, and value creation. Banks should act as investors, rather than mere creditors, ultimately aiming at long-term profitable banking relationships with their clients. A first step in this direction is the use of business plans to obtain important information about a firm’s prospects and its ability to manage uncertainty. The crisis made banks rethink their true role in business. Their job is to invest, not simply lend. And believe me, there is a great difference between the two…

* MSc in Finance; MSc in International Business & Management; MSc in Business for Lawyers; MSc in Entrepreneurship at ALBA Graduate Business School at The American College of Greece

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