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The misconception of the option value of deposit insurance and the efficacy of non-risk-based capital requirements in the literature on bank capital regulation

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  • Paolo Fegatelli

Abstract

This study shows how the misconception of the option value of deposit insurance by Merton (1977) and its later misuse by Keeley and Furlong (1990), among others, have led some literature supporting the adoption of binding non-risk-based capital requirements to derive incorrect conclusions about their efficacy. This study further shows that what Merton defines as the option value of deposit insurance is actually a component of a bank?s limited liability option under a third-party deposit guarantee. As such, it is already included in the value of the bank?s equity capital, and the flawed definition makes the Keeley-Furlong model internally incoherent.

Suggested Citation

  • Paolo Fegatelli, 2010. "The misconception of the option value of deposit insurance and the efficacy of non-risk-based capital requirements in the literature on bank capital regulation," BCL working papers 46, Central Bank of Luxembourg.
    • Handle: RePEc:bcl:bclwop:bclwp046
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    File URL: https://www.bcl.lu/fr/Recherche/publications/cahiers_etudes/46/BCLWP046.pdf
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    References listed on IDEAS

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    2. Delis, Manthos D. & Tran, Kien C. & Tsionas, Efthymios G., 2012. "Quantifying and explaining parameter heterogeneity in the capital regulation-bank risk nexus," Journal of Financial Stability, Elsevier, vol. 8(2), pages 57-68.

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    More about this item

    Keywords

    Capital requirements; Credit risk; Deposit insurance; Prudential regulation; Portfolio approach;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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