The non-traditional bank’s principal profit line is income from non-interest trading activities. In 2007-2008, US banks with a high income share from unconventional operations such as investment banking and asset securitization were at the epicenter of the US financial crisis.
The financial crisis lowered the living standards of developing countries and increased worldwide poverty. Banks preferred to diversify into unconventional banking operations such as investment banking, but the crisis exposed the shortcomings of investment banking as well as the banks’ business models.
The crisis spread quickly over the world because international financial governance lacked the necessary instruments and mechanisms to contain it. Banks had not implemented a business model that allowed them to transfer credit risk to private investors, entrepreneurs, and nonbanking institutions without holding client deposits as assets.
The banks’ interest proceeds from selling funds were unjust and did not benefit both depositors and the bank. To maximize profit, the traditional bank lends depositors’ funds at more than twice the deposit interest rate.
Despite the fact that the fund belongs to depositors, banks pay a lower price than the lending price in order for depositors to profit significantly.
Using customer deposits as assets on the bank’s balance sheet, on the other hand, exposed them to credit risk and a liquidity crunch, which can always be the source of a financial collapse.
To safeguard the banking industry from such risks, they were forced to move their risks to nonbanking institutions, individual investors, and entrepreneurs. The risk can be eliminated by applying the Interest Rate Commission Agent Banking System (AIRCABS).
The system adopted by the bank as an agent for investor loan funding to entrepreneurs has the seller and buyer agree to administer the loan after disbursement. It can also collect the agreed commission from investors’ loan funding credit price.
Loan transactions that undergo AIRCABS are liberalized between investors and entrepreneurs. Because of this, the agent bank is exempt from paying the financial expense out of the customer deposit. Since the agent bank has administered the loan after disbursement in an authentic manner, no moral hazard is expected among investors, entrepreneurs, and the bank itself. Administering services and investor loan funding through the system helped mobilize stable bank deposits.
The most difficult factor for traditional banks is the fierce competition for service excellence. Since their profit source is the customer deposit, the increase in money withdrawals led to a liquidity drain, which increased the bank’s nonperforming assets resulting from customer-defaulted loans.
The main contributors to the bank’s credit risk were the borrowers’ weak knowledge of loan administration, the bank’s credit assessment, and external factors such as the unexpected tax burden on the borrower’s business and commodity price shock. However, in order to mobilize loans and deposits at the same time, the system shifted credit risk and liquidity constraints to investors and entrepreneurs.
There is a misconception that loans attract deposit mobilization. As bank loans advanced, the number of clients who sought a loan to deposit their money increased. This could happen when the banks mobilize stable deposits from time to time.
To increase the volume of loans, banks should manage loans and deposits in a compatible manner for a reasonable profit. Over-leveraging and underperforming loans can potentially render savings and loans vulnerable to financial shocks, thus contributing to financial instability.
However, AIRCABS administers the fund of investors based on the lending strategies, such as 360 degrees, 180 degrees, and 90 degrees, to collect interest rate commissions and fees from investors. Since the loan was given out and managed by the agent bank, it is more likely than not that the loan will not become a nonperforming asset.
360-degree lending
The parties involved in this lending strategy are the investor, the entrepreneur, and the agent bank. In this lending strategy, the investor and the entrepreneur had a strong working relationship, and the collateral that will be pledged by the entrepreneur to get a loan from the investor is optional. Here, the project to be financed would be selected by an investor. Following the selection of a project by an investor, the investor and entrepreneur present it to an agent bank for financing from the investor’s fund to the entrepreneur.
The agent bank administers the loan after disbursement to an entrepreneur on behalf of an investor who assessed the feasibility study of the entrepreneur before the three parties entered into a loan contract.
During the loan period, the agent bank can transfer the loan to an investor who has the capacity to buy the loan if the existing investor fails to continue until the loan has been settled. If an entrepreneur fails to pay the loan during the loan period, the agent bank rents the financed project to a new entrepreneur until the loan has been settled, after which the project will be returned to the original entrepreneur.
The agent bank rents an entrepreneur’s project without transferring ownership, which can be done at the investor’s and the agent bank’s discretion. The business owner who rented the project gets the extra money from the business over and above the amount set in the loan contract.
180-degree lending
Here, the investor and the entrepreneur are unknown to each other and are presented to the agent bank at different times. An investor who is looking for a feasible project to finance consults the agent bank, which later searches for a feasible project among entrepreneurs who have already applied for a loan through the agent bank.
If an agent bank did not have a feasible project according to the investor’s application, it would search for a feasible project on the market. While the agent bank selects a feasible project on behalf of an investor, the agent bank collects the project selection fee from the investor. Because the investor and the entrepreneur are unknown to each other, collateral pledges by the entrepreneur are required.
If an investor fails to complete the loan period, the agent bank sells the loan to a new market investor. If an entrepreneur fails to pay the loan, the agent bank rents out the project to a new entrepreneur who has the same interest in the market.
Where there is no hope to collect the debt from an entrepreneur, the agent bank sells the collateral to collect the remaining debt amount. Collateral may be the project under investment or another asset.
The collateral pledged against the loan disbursed from an investor’s account should have a safe margin rate between 91 and 100 percent for a 90 percent loan on the collateral value, unless an entrepreneur covers the remaining more than or equal to 10 percent of the safe margin by buying insurance from an insurance company.
The insurance company may cover the default amount beyond the original loan balance or according to the agreement between the entrepreneur and the insurance company.
Here, the agent bank may not advise the entrepreneur to buy insurance coverage for loan repayment; rather, it manages the loan to get paid in due time as specified in the loan contract.
Otherwise, if an entrepreneur fails to pay the debt obligation above 100 percent of the collateral value, the agent bank would auction the collateral together with the project under investment. It is also obliged to collect the fund disbursed together with the interest accrued to reimburse the remaining unpaid balance to the investor and its uncollected interest rate commission and additional administrative expense.
The agent bank sells the pledged collateral when no alternative investment solution can be found. However, the main target of the agent bank is to benefit the investor and the entrepreneur by mitigating the risk related to the entrepreneur’s business. Therefore, the agent bank rents the project to a new entrant that has the same project interest until the loan is settled, holding the collateral and preventing ownership transfer.
The benefit of the new entrant is that the business runs with the support of the entrepreneur’s own fund, which is equal to or greater than the current loan repayment, has full-fledged facilities, and collects business profit beyond loan repayment for the investor. The exiting entrepreneur does not lose its property since the property will be returned after the loan has been settled by the new entrepreneur.
The rent for the existing entrepreneur’s project is calculated by dividing the loan by the entrepreneur’s total assets. If the loan to total asset ratio was calculated to be greater than 100 percent, the rent would be higher than the current loan repayment. If the loan to total asset ratio is less than 100 percent, the rent could be equal to or greater than the loan repayment to settle the loan by its due date.
Here, the agent bank transfers the credit risk of an investor and an entrepreneur to new entrants.
90-degree lending
The parties involved in this lending strategy are the money depositor and the bank. To run this lending strategy, the bank should adopt an interest rate commission agent bank as one unit of the bank. The bank’s depositors can shift to the investor position to collect credit price in the form of a deposit interest rate on funds already invested by the bank, which later shifted to the agent position for the depositor, who then became an investor.
In this strategy, the depositor, who wishes to be an investor during the deposit periods, consults with the bank that has already invested the depositor’s funds in a selective project. The bank shifts to agent status after a formal agreement is made between the investor and the agent bank for the portion of funds invested.
The agent bank stops calculating deposit interest, the newly entrant investor benefits from a proportional credit price according to the funds considered in the total fund that is already disbursed by the bank to the debtor, and thereby the agent bank collects a proportional interest rate commission from the investor credit price.
This can be done because an interest rate commission agent banking system can be a unit of a bank that runs under a conventional banking system. The loan already disbursed to a debtor is covered by insurance and secured by pledged collateral. So, when a depositor changes from a depositor to an investor during the deposit period, the investor’s credit risk moves to the collateral pledged and insurance bought by the entrepreneur.
The high-level expert group put out a final report to set up a separate legal entity that does business by taking deposits from the public and giving financial services to the non-financial sector of the economy that are related to lower-risk trading activities.
However, this newly proposed separate bank system was unclear as to the risks since the customers’ money deposits were considered the bank’s assets. In contrast, the bank considered getting the proceeds from the sale of the deposit.
Investors and entrepreneurs consider customer deposits assets unless banks transfer their credit and liquidity risks to nonfinancial institutions. The system enabled working with traditional banking activities to enhance stable deposit mobilization. This can be done by creating alternative investment opportunities for depositors.
A business model adopted by the banks made them either retain risk or transfer it to other financial institutions. An interest rate and commission agent banking business model transfers credit and liquidity risk to individuals by increasing the bank’s sustainability and profitability with stable deposits. So AIRCABS is reliable and valid in the banking industry.
Ameha Tefera (PhD) is a financial expert. He can be reached at [email protected].
Contributed by Ameha Tefera
