Banking Stability System: Does it Matter if the Rate of Return is Fixed or Stochastic?

TL;DR

This paper compares fixed and stochastic return banking models, demonstrating conditions under which stochastic models can be more preferred and improve overall economic welfare.

Contribution

It introduces a framework to analyze investor preferences and welfare implications between fixed and stochastic return banking systems.

Findings

Banks may prefer stochastic return models under certain investor share conditions.

Economic welfare can be improved through stochastic return models in a Pareto-efficient manner.

Conditions for investor and bank preferences are mathematically derived.

Abstract

The purpose is to compare the perfect Stochastic Return (SR) model like Islamic banks to the Fixed Return (FR) model as in conventional banks by measuring up their impacts at the macroeconomic level. We prove that if the optimal choice of investor share in SR model {\alpha}* realizes the indifference of the financial institution toward SR and FR models, there exists {\alpha} less than {\alpha}* such that the banks strictly prefers the SR model. Also, there exists {\alpha}, {\gamma} and {\lambda} verifying the conditions of {\alpha}-sharing such that each party in economy can be better under the SR model and the economic welfare could be improved in a Pareto-efficient way.