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Development Banking Model

Summary
Starting point of the PhD project with the working title development banking in
industrialized countries on the example of German regional development
banks is that the role and functioning of development banking in developing and
transition countries is well researched and understood, in contrast to development
banks in industrialized countries with in principal functioning finance markets and
available funds. Germany has a particular dense system with two national and 17
regional development banks. On the basis of case study research for this cluster of
banks it is intended to build a business model for them that shall be useful for two
purposes: the first being an additional managing tool for its executives (inside-out
view) and the second a tool for the public shareholders to govern and supervise
their development finance institution (outside-in view).
In order to develop a first model, a blueprint model of a commercial bank from
Finkenwirth/Doll (1988) has been taken and a first draft of a development banking
model has been derived from it.

It is intended to develop the preliminary model further on by taking a closer look at
the potential boundaries in the aim to clearly define the most adequate scope of the
model and by deciding about an inclusion of system dynamic of accounting.

It is the authors intention to present a further developed model during the PhD-
Seminar and to get feedback on the two modelling approaches from SD-experts.
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1. Objective of the Study and Research Question
The intended contribution to the body of knowledge is a framework and a business
model for development banks in industrialized countries. The contribution is aimed to
be at four levels: for the development banking industry to contribute to a deeper
understanding of the rationale of the development banks; for the supervising
ministries to ease the governance process, and in the field of business modelling to
contribute to the needs of specific business models for different industries. Finally, it
is intended to contribute to society by deepening the understanding of how to
effectively and efficiently use development banking for business, housing and
infrastructural promotion-related activities in order to improve further our society.

The project aims at answering the following research questions:
What is the rationale of development banks in developed countries?
How can this group of banks be measured and evaluated in regard to their
performance and impact? (In contrast to singular promotional schemes, where
evaluation and impact analysis is regularly carried out, this is not the case for
whole finance institutions.)
In which ways does the German development banking systems differ from
promotional systems in other countries?
What is the performance and impact of the German regional development
banks compared to the systems of other countries?
How are development banks in developed countries to be managed by their
executives, governed and controlled by their shareholders and supervised by
their supervisory bodies in order to maximise their added value for their
stakeholders?
Is development banking adequately used? Are there an underperformance of
the development banks and an over/underuse of development banking?
2. Background
Development Banking can be defined as debt lending, equity investment, and related
consulting activities that is carried out with the aim to overcome market failure, and
/or to promote business, urban development as well as housing. Development
banking can be seen as an instrument to turn political initiatives into action.
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It can be carried out by development finance institutions such as development banks
and development agencies. They exist on a worldwide, world-regional, national,
regional, and at communal level. Independent from their scope and geographical
orientation, they are mostly state-owned and have a certain mission in their statutes.
These institutions use generally a set of instruments which are specific for
development banking and which differ from the commercial banks ones. These are
in particular the following forms of debt, equity finance, guarantees and grants:
- Global loans
- Sub-loans
- Syndicated loans
- Micro loans
Subsidised loans
- Venture capital
- Counter-guarantees as substitute for collateral
- Investment-stimulating grants
- R&D-stimulating grants
Due to their state ownership, and state backing, development banks have generally a
comparably good rating that allows them a refinancing at preferred conditions. This,
in return, allows them to invest in assets, to profit from interest rate gaps and to use
the yield for its promotion related activities, e.g. for interest rate subsidies.
3. Literature Review
3.1. Literature Review on Development Banking
Already Joseph Schumpeter described in his book The Theory of Economic
Development, published in German in 1912 and in English in 1934 the connection
between financial and economic development. Schumpeter argues that banking and
entrepreneurship are the two key agents in the process of economic development.
He contends that financial development causes economic development, as financial
markets promote growth by funding entrepreneurs and channel capital to high return
projects.
Gerschenkron (1966) took the industrialization of the countries in Continental Europe
as the starting point to develop his theory about countries backwardness and their
catching up by the implementation of substitute institutions. Gerschenkrons analysis
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was the starting point of Kanes study of 1975 about development banks in
developing countries.
Kane (1975) generates in Development Banking An Economic Appraisal a
development bank and banking theory. Kane proceeds from the assumption that
development banks exist with the goal of closing the gap between the
industrialization level of their home country and that of industrialized countries. He
bases his approach on Alexander Gerschenkrons theory of industrial development
(1965:5-30) that deals explicitly with financial institutions. Kane (1975:184) points out:
Gerschenkron has suggested that the more backward a country is on the eve of its
industrialization the more it will create substitutes for conditions and institutions which
were preconditions for industrialization in countries developing ahead of it but which
are absent in its own case. According to Kane development banks are a substitute
institution for narrow or non-functioning finance markets in developing countries. By
using development banks as substitute institutions, developing countries would be
able skip several stages of development that the industrialized countries have gone
through and thus be able to develop in a faster way and close up with them.
Gerschenkrons theory permeates the whole book. According to Gerschenkrons
theory, development banks in developed countries would have only marginal effects.
Kane (1975:61) points out: In the developed countries, also, development bank-like
institutions have only a marginal role to play, since alternative sources of capital
supply tend to exist both externally in the capital market and, for established firms
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,
internally through accumulated retained earnings. Although Gerschenkrons theory
is obviously not suitable to explain the existence and the role development banks
play in developed countries, the concept of different stages of development resulting
in a shortage of projects and/or capital seems suited to do so partially if applied to
specific industries that lack access to finance. Kane picks up the concept about
limited utility of development banks, originally developed by Sayre P. Schatz (Schatz
1964:114119). Whereas Schatz uses the concept in a macroeconomic context,
Kane does so it with a microeconomic frame of reference. Kane (1975:171) believes
that despite the sometimes small impact of a development bank on aggregate
investment, it is worthwhile for development policy at this time to evaluate the
contribution of the development bank viewed as a microeconomic unit, that is as a

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In the book it reads forms instead of firms.
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bank. The writer has interpreted the hypothesis in this microeconomic sense,
evaluating development bank performance, given the resources at its disposal, given
the constraints of an underdeveloped economy, given the performance of other
financial institutions in the same economy, and given the policy decisions of
government. Kane had undertaken a quantitative research study with a sample of 31
development banks, all from developing countries. He analyses the sample so as to
verify or falsify the hypothesis of limited utility. Kane (1975:1717) concludes: Based
on the evidence at hand, the data do not appear to support the hypothesis of limited
utility. The alternative conclusion implied is that industrial development banks can
make an effective contribution as development finance institutions to industrial
development in the development countries.
Kane (1975:88) addresses the issue of development bank-like institutions in
developed countries by concluding: Institutions roughly similar to development
banks do exist in developed countries. Available evidence suggests that they play a
very marginal role in financial intermediation and in the provision of related services.
This conclusion can be explained by the fact that he sticks to the paradigm of
development banks as substitute institutions for narrow or non-existing finance
markets. Therefore the reasoning of Kane is not suitable for the explanation of
development banking in developed countries. His theory can hence not be used
without major adoptions for developed countries. In addition, as the theory dates
back to 1975 it does not take into account the theory and new concepts in finance
and economic development of the last 35 years.
De Aghion (1999) develops in her paper a model of a (laissez-faire) decentralized
banking system in which banks are shown to both underinvest in (1999:83), and
under-transmit expertise in long-term industrial finance for new industries. The
relevance of the analysis for development banks in developing countries is discussed
by contrasting the successful historical development banking experience of France
with the more recent unsuccessful experience of Mexico (de Aghion 1999:83). She
concludes that government support for the development bank can serve to reduce
these problems, but only if it grants loans by co-financing arrangements and/or co-
ownership with private financial institutions (de Aghion 1999:84). De Aghion builds on
a framework of Dewatripont and Maskin (Dewatripont/Maskin 1995) who suggest a
role for coordinating agencies in order to overcome free-rider problems and to
prevent possible shortermism in the form of underinvestment and under-
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transmittance in long-term industrial finance (de Aghion 1999:84). On this basis she
develops a model of a (laissez-faire) decentralized banking system. In this system,
commercial banks are reluctant to finance on a long-term basis and new industries.
She then proceeds from the assumption that in this system a free-rider problem
occurs when two or more banks make co-financing arrangements for the financing of
a project in an innovative industry where new expertise is needed. The bank that
acquires such expertise first will make profit the other bank from its knowledge by two
levels: the first level being the professional evaluation of the project and the second
being the transfer of the acquired expertise in the context of the financing procedure.
In the model banking system there is no transparency of the knowledge base of the
respective banks and the bank that has acquired the needed expertise for the
financing of innovative projects prior to the financing procedure is not rewarded for it.
The free rider problem occurs: According to de Aghion this would lead to the fact that
the banks would rely on each other for having acquired the needed expertise prior to
the financing procedure without acquiring it on their own. The effect for the model
banking system is that there is only limited expertise for new industries available
resulting in an underperformance in the financing in new industries. At this point the
development bank comes into play. The development bank could help to overcome
the free rider problem by acquiring and providing expertise for the financing of new
industries. De Aghion analyzes under which conditions the development bank may
help to overcome the general shortage of long-term financing and the availability of
finance for new industries. De Aghions (1999:85) findings are that:
unqualified government support alone is not enough. The efficiency of
government sponsorship can be enhanced if certain conditions are attached to
that sponsorship. Crucially, these include targeting of development bank
intervention, co-financing arrangement and/or co-ownership with private
financial institutions.

In the era of deregulation and financial liberalization development banks had been
widely regarded as not fitting into a free market economy in which risk was usually
taken by commercial banks. I.e. development banking had been widely regarded as
outdated. Former communist countries in Eastern Europe and developing countries
therefore had been encouraged to dissolve public banks and/or were discouraged to
establish new development banks. However, this has changed over the last years:
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Most of the Eastern and Southern European countries have again set up
development banks (Schmit et al, 2011). In addition, the Final Report prepared for
the UN 2005 World Summit, Segment on Financing for Development, September 14-
16, 2005 recommends the establishment of national development banks in order to
provide affordable long-term financing, as well as technical assistance, to areas and
sectors not adequately serviced by the private sector. And in the Doha Declaration
from the UN of 2008 the development banks are explicitly mentioned in order to
promote the development of domestic capital markets.

Thorne and du Toit (2009:677694) have developed a macro-framework for
successful development banking. The framework consists of the following six
dimensions (2009:678): enabling environment, mandate, regulation and supervision,
governance and management, financial sustainability, and performance
assessment. For each dimension certain principles are set out and summarized in
the following way (2009:689f):
Their environment: Development banks need a climate of macro-
economic stability without too many micro-economic distortions; they
require political stability and a variety of complementary institutions.
Although by definition their role is to address some of the weaknesses
in the environment, they cannot succeed in a largely dysfunctional
climate.
Their role in it: They must be integrated into the financial system and
operate along commercial lines, with a flexible mandate. They must not
compete with the private sector, but rather aim to develop it. Once the
private sector has the capacity to fund sectors previously funded by a
development bank, the latter should be refocused on other areas of
operation.
How they are controlled: The ownership role of the state needs to be
carried out circumspectly, allowing the bank to have operational
autonomy while ensuring that it adheres to its mandate. The combined
ownership and oversight role of government creates a potential conflict
of interest that requires careful management. In general, the regulation
and supervision of development banks should be along private sector
lines.
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How they are run: Sound governance and management may be the
single factor most likely to determine the success of a development
bank. This involves issues such as the role and independence of the
board, the accountability and capacity of management, the availability
and retention of skilled staff, and sound operational, risk and financial
management.
How they are funded: The government needs to capitalise new (or
restructured) development banks adequately, and then limit additional
fiscal support to ring-fenced non-commercial activities undertaken on
behalf of the state. Development banks should be encouraged to
approach donors and obtain a credit rating to enable them to raise
funds on the capital markets.
Do they make a difference? Development banks should be assessed
on a regular basis against an agreed set of objectives, both financial
and social or developmental. Government must also be convinced that
it could not have achieved these socially desirable outcomes in another
(less expensive) way.
Thorne and du Toit conclude (2009:691): Since development banks operate under
different conditions and in different markets, the framework can be adjusted to suit
the development priorities of individual countries.
3.2. Research Questions from the Development Banking Literature Review
The literature review leads to the conclusion that there is a gap in respect to
development banking in industrialized countries. In particular the issue of good
governance and impact analysis has been mentioned:
- Thorne (2008) has defined in her doctoral thesis Towards Financing
Development: An Economic Framework for Development Banking as areas
for future research inter alia government issues, benchmarking and sectoral
analyses.
- Schfer/Zimmermann (2008) highlight in their article (in German) Enterprise
financing are development banks still up to date? the scarce knowledge of
the specific impact that the activities of development banks have on
enterprises.
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4. Research Approach
4.1. Business Modelling
The purpose of this study is to develop a business model for development banks in
developed countries. Osterwalder (2004:4) describes the reasoning behind business
model research as a problem solution finding approach. It is about finding the
concepts and relationships that allow expressing the business logic of a firm in order
to be able to formally seize the business logic. It means designing and building a
model that makes it possible to represent the business model of a firm.
According to Schwaninger (2009:2) the role of models for managerial purposes has
been under-researched and often misunderstood and the use of models in
organizations has by and large been subject to little reflection (2009:3). Schwaninger
et al (2007:3) perceive it as surprising that the use of models as a basis for general
management has attracted only sparse attention in the abundant literature of that
field. As business model research is still in its early days (Lambert 2006:1), a
standardized approach of how to built business models does not yet exist, and until
now there is no common understanding of it and for which purposes they qualify. For
the understanding of business models design science, model-based science and
systems thinking play all three a crucial role. Thus it seems most suitable to
approach the topic by further examining first the super-ordinate topics design
science, model-based science, systems thinking and model-based management and
then to tackle the field of business modelling. The latter shall then be discussed in
general with a analysis of different approaches and the aim to analyse the most
suitable for the study.
4.2. Design Science
The design science approach is quite different from the one of the conventional
natural science. Rather than posing theories, design scientists strive to create
models, methods, and implementations that are innovative and valuable (March et al
1995:254). Van Aken describes the mission of design science as the development of
knowledge that the professionals of the discipline in question can use to design
solutions for their field problems (2005:20). The basic activities of design science are
building and evaluating (March et al 1995). This is in contrast to natural science,
where scientific claims are proposed during the building phase, which then are tested
during the evaluation phase (Kaplan 1998). Whereas natural science tries to
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understand reality, design science attempts to create things that serve human
purposes. Its products are assessed against criteria of value or utility does it
work? Is it an improvement? (March et al 1995:253). Design science is traditionally
used in fields like architecture, engineering, urban planning (March et al 1995),
medicine and Information Science. Design science is also a suitable scientific
approach in management and suitable for the mode-2 research approach (Van Aken
2005). According to March et al (1995) the outcomes of design science consists of
constructs (phenomena-characterizing language), models (used to describe tasks,
situations, or artifacts) methods (ways of goal-directed activities), and
implementations (products intended to perform certain tasks).
4.3. Model-based Science
According to Godfrey-Smith (2006:730) model-based science is fundamentally a
strategy of indirect representation of the world. A model is an abstract, conceptual
representation of a real system (Schwaninger 2009) that is aimed at understanding
the real system. Model-based Science consists of a two-step approach (Godfrey-
Smith): The first step being to design a hypothetical system or structure. The second
step consists in considering the resemblance relations between the hypothetical
system or structure and the real world system or structure that is aimed at
understanding (Godfrey-Smith 2006). Model-based science has traditionally not been
considered as a significant form of scientific reasoning by philosophy (Nersessian
1999). However from todays point of view, models are one of the critical instruments
of modern science (Morgan/Morrison 1999:10). Modelling as an element in
scientific methodology and models as the outcome of modelling are both important
aspects of the conduct of science (Gilbert 2008:3). Models can play a crucial role as
a mediator between theory and the target system as part of the world
(Morgan/Morrison 1999:10). The interaction can be between theory and empirical
evidence obtained from observation (Morgan 1999:7). Models can also be used as a
tool to help form and explore theoretical concepts (Morgan 1999:6). Nersessian
(1999) specifies three forms of model-based reasoning: analogical modelling, visual
modelling, and thought experimenting. Models in the form of physical objects seem
not to be relevant for the scope of the study. Nersessian qualifies these forms of
reasoning as productive methods of conceptual change (1999:2).
Analogical modelling is to use a target system to represent another, more
understandable and easier to analyse system (Hesse 1966, 2000, Cornujols 1996).
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Visual modelling shall be defined as to graphically represent the objects and systems
of interest. Visual modelling is concerned with the formation of an internal
representation from an external representation such that the nature and
temporal/spatial relationships between the entities of which it is composed are
retained (Gilbert 2008:4). Thought experiments are devices of the imagination used
to investigate the nature of things (Brown et al 2010). Thought experiments are
usually carried out in the following way: We visualize some situation; we carry out an
operation; we see what happens, and we draw a conclusion (Brown et al 2010).
According to Morgan (2001) narrative elements are an integral part of models in that
way that models help us to understand the economic world by telling stories about
the real world or about a hypothetical world the model is about. She argues that
modelling makes only sense if there is additional information about it. Thus, a model
without the models story would not make much sense. There are many reasons for
model building. Epstein (2008:2f) gives the following 17 reasons for building models:
1. Predict
2. Explain (very distinct from predict)
3. Guide data collection
4. Illuminate core dynamics
5. Suggest dynamical analogies
6. Discover new questions
7. Promote a scientific habit of mind
8. Bound (bracket) outcomes to plausible ranges
9. Illuminate core uncertainties
10. Offer crisis options in near-real time
11. Demonstrate tradeoffs / suggest efficiencies
12. Challenge the robustness of prevailing theory through perturbations
13. Expose prevailing wisdom as incompatible with available data
14. Train practitioners
15. Discipline the policy dialogue
16. Educate the general public
17. Reveal the apparently simple (complex) to be complex (simple).
It is conventional amongst philosophers of science to think of models in their relation
to theory, and thus to concentrate on the model-theory relationship (Morgan 2001:1).
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However, the relationship between the model and reality seems to be at least as
important. Morgan (2001:1) describes this relationship as follows: Modelling involves
a style of scientific thinking in which the argument is structured by the model but in
which the application is achieved via narrative prompted by an external fact, an
imagined event or question to be answered.
5. Model Development with System Dynamics
In the following main questions for the development of a system dynamics model for
German regional development banks shall be raised and discussed. In addition, a
model will be derived from an existing commercial bank model.
5.1. Models Boundaries
Boundary critique is the concept in critical systems thinking, according to Ulrich
(2002) that states that "both the meaning and the validity of professional propositions
always depend on boundary judgments as to what 'facts' (observation) and 'norms'
(valuation standards) are to be considered relevant" or not. This concept applies in
particular for development banks since their mission is not only to make profits or to
be at least cost covering but to fulfil a mission which consists of multiple aspects
such as job creation and at the end of the day to have a positive impact on the
domestic product. Therefore a holistic macroeconomic model that would cover the
whole catchment area would be ideal. However, where such models exist, they are to
the knowledge of the author not specific enough and do of course not cover
development banks. And such a model would be much too complex to be suitable for
the use in the banks and by the supervising ministries. Thus the boundaries shall be
as narrowly defined as possible to keep the model lean and as clear as possible.
Never the less it will not be enough to focus on the banks model alone since the
development banks model needs to include aspects such as job creation.
5.2. Dynamical Hypotheses
The following preliminary dynamical hypotheses shall be defined:
- The development bank acts upon input variables from at least four sources:
regional government policy and tasks, sectoral markets (in particular SME and
housing), the regional finance market (commercial, savings and cooperative
banks) and the overall finance and money markets.
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- The development banks profitability depends on the promotion-
intensiveness of its mission and tasks: The more promotional activities it
carries out in comparison to its treasury and syndication activities, the lower its
profitability will become. Additional sources of subsidies may relativize that.
- The more a development bank offers promotional schemes, e.g. in the form of
subsidised loans, the better this is for the enterprises. However, there is a risk
of a crowding out of (non-subsidised) loans from private sector banks.
- There is a trade-off between the financing activities of development banks and
the commercial banks: Up to a certain level, commercial banks appreciate the
development banks activities; it allows them to increase their financing and to
optimize their risk taking. From a certain level on, commercial banks feel the
development banks activities as a competition and a threat for crowding out.
5.3. Important Feedback Loops
From the abovementioned dynamical hypotheses feedback loops may be derived. In
the following Figure, first elements of such a feedback loops are shown:


Figure 1: First Elements of a Feedback Loop for a Development Banking Model
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5.4. Expected Insights
The expected main insight of the model is how to optimize the added value of the
development bank for the various stakeholders and how to deal best with trade-offs,
goal-conflicts and counter-intuitive feedback-loops.
5.5. In Search of a Blueprint Model
Starting point for the model development for a business model for regional German
development banks has been to search an already existing model that might be used
as a blueprint. Unfortunately no such model was available in the System Dynamics
Societies case database (http://cases.systemdynamics.org). Thus the research has
been expanded to the System Dynamics Societies literature bibliography
(http://www.systemdynamics.org/biblio/sdbib-download.html) by the keywords
development bank, banking industry and bank. While the first two keywords had
no hit, there were several hits for bank and one source that contains a system
dynamics models for a bank: Finkenwirth/Doll (1988) present a banking model of a
London branch of a Continental commercial bank. The simplified structure of the
model is shown in figure 1:

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Figure 2: Simplified London branch model of a Continental commercial bank (Source:
Finkenwirth/Doll, 1988: 67)

In the following, the differences between this commercial bank model and a typical
German regional development bank structure shall be analysed in order to be able to
adapt the model to a German regional development bank one:
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No. Commercial Bank Development Bank
1 Head office restrictions Strategy sector and head office are identical.
Regional government is shareholder and defines mission
and specific tasks the development needs to accomplish
in addition to be profitable or at least cost covering.
2 4 kinds of products are on offer:
traditional, specialized,
contingent and treasury products
Typical product portfolio as abovementioned under
section 2.;
3 to 4 SBU
2
: (1) business promotion, (2) housing and
urban development, (3) treasury, (4) public sector
3 Three Profit Centres Only treasury is purely profit oriented, the other SBU are
promotion-oriented and may range from profit making,
cost-covering to loss making and in need of cross-
subsidising from treasury and other sources
4 - Development banks generally have access to subsidies
from different sources (regional and national government,
EU)
Table 1: differences between this commercial bank model and a typical German
regional development bank structure

Finkenwirth/Doll (1988: 66) elaborate: The analysed bank is the London branch of a
Continental bank. The branch acts on the markets as a commercial bank. These kind
of representations are the most common ones in the financial center of London. The
branch offers four different kind of products: Traditional, specialized, contingent and
treasury products. These products determine the statement of asset and liabilities
and in addition are also the income earners of the branch. The behaviour of the
branch is determined by decision rules, market developments, the juristical position
and internal restrictions. This behaviour is tested by adopting different scenarios. The
System Dynamics bank model is adaptable to individual circumstances of other
banks and therefore it offers practical support for the management of financial
institutions.
5.6. Development Banking Model
From the differences between the commercial banks and the development banks
situation as shown in Table 1, a development banks model can be derived from the
commercial banks model as follows:

2
SBU = Strategic Business Units
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Figure 3: Simplified Development Bank Model
6. Next Steps
It is intended to develop the above designed preliminary model further on as follows:
- Taking a closer look at the potential boundaries in the aim to clearly define the
most adequate scope of the model.
- To decide about an inclusion of system dynamic of accounting (will it help to
make the model clearer or will it make it even more in need of explanation?)
An Introduction to Financial Accounting Model from a System Dynamics
Perspective is given by Melse (2006). A system dynamic model of accounting
for the banking system is given by Franco, D. (1985).

It is the authors intention to present a further developed model during the PhD-
Seminar and to get feedback on the two modelling approaches.
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Sources:

Finkenwirth, A. / G. Doll (1988): System Dynamics Simulations for the Management
of a Commercial Bank, in: Proceedings of the 1988 International Conference of the
System Dynamics Society. J. B. Homer and A. Ford. La Jolla, California, International
System Dynamics Society, 1988, pp. 65-77.

Franco, D. (1985): The Banking System: a System Dynamic Profile, in: Proceedings
of the 1985 International Conference of the System Dynamics Society. Keystone,
Colorado, International System Dynamics Society, 1985, pp. 249-258.

Melse, E. (2006): The Financial Accounting Model from a System Dynamics'
Perspective, 2006, pp. 1-26, available at SSRN: http://ssrn.com/abstract=1081620 or
http://dx.doi.org/10.2139/ssrn.1081620.

Ulrich, W. (2002): Boundary Critique, in: The Informed Student Guide to
Management Science, ed. by Daellenbach, H.G. / Flood, R.L., London, 2002, p. 41 f.

(still to be completed, I apologize for not having been able to deliver a complete list.)