Rediscovering the role of banks in business financing: From mere lender to business partner.

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: One of the most basic lessons in corporate finance is the role of Banks in capital markets which is demonstrated by the famous “separation theorem”. By allowing investors either to borrow or save along with their investment in equity (efficient-market portfolio) they are able to achieve investment combinations that best match their personal preference towards risk. By borrowing, investors can leverage their investment to a higher level of expected return but with the inevitable exposure to a higher level of risk. The opposite occurs with the saving function made available by banks that lead to de-leverage offering investment choices of lower risk but lower return as well.

Lesson 2: Apart from the above lesson in corporate finance, there is another, equally important lesson being taught in banking and risk management courses: The role of banks in handling the financial risk itself; that is, the perception of banks as risk transformers in analogy of the electrical ones: They accept high voltage and they transform it to low one. While offering the highest possible collateral to their depositors, they accept a much higher risk of default from borrowers (businesses and households). The above risk difference highlights the need for effective risk management; otherwise, the transformer (either electrical or risk one) might melt down. Although the banks take a number of steps to secure the loans they have provided, credit risk can never be completely eliminated in the sense that it will always cause some damage due to credit default.

The recent crisis and the negative consequences it has caused, reminded us that banks have a much more important role than just "selling" loans. Blurred by the aggressive efforts to sell credit to households and firms during the pre-crisis period, people almost forgot the true role of Banks and their contribution to economic development. Instead, banks were accused of underutilizing society’ resources, promoting the interests of bank executives (golden boys) and destroying value. Some might think that this is the way banks work and nothing can be done to change that. Well, allow me to disagree.

Lesson 3: Empirical evidence and real life experience has shown many times that any loan guarantees do not offer full protection against credit risk. The crucial question that banks have to answer is how they should avoid credit default to ever happen and not what compensation they will seek in case is realized. As a matter of fact, in a systemic crisis like the one we have experienced, any traditional protection in the form of collateral or other guarantee has proven to be almost totally ineffective.

What have we learned from the above lessons? The best protection against default risk is for banks to lend to those firms that have the potential for business sustainability, growth, and value creation. For this reason, the bank should act as an investor and not simply as a creditor, ultimately aiming at a long-term and profitable banking relationship with its clients. A first step towards this direction is the use of business plans to obtain important information about the prospects of the firm and its ability to manage uncertainty. The lesson that banks took from the crisis made them rethink of their true role in business.  Their job is to invest and not simply lend. And believe me, there is a great difference between these two…