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The valuation of deposit insurance allowing for the interest rate spread and early-bankruptcy risk

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  • Chiang, Shu Ling
  • Tsai, Ming Shann

Abstract

Our proposed model allows for inclusion of the interest rate spread (defined as the difference between the lending rate and the borrowing rate) and the risk of a bank’s early bankruptcy in the derivation of a closed-form pricing formula for calculating deposit insurance premiums. This is important because, in practice, these two factors significantly influence the expected value of a bank’s assets. Also, we use a method that considers the possibility of early bankruptcy to derive new formulas for calibrating the necessary parameters. Data from Taiwanese banks are used to illustrate the application of our model. Our empirical results show that the spread of the interest rate is negatively correlated with the premium. This result is consistent with our theoretical inferences. Moreover, premiums associated with a risk of early bankruptcy are always higher than premiums not associated with such a risk. Using the example of Taiwanese banks, we show that the traditional model underprices the premium by 20.81% if it does not consider the risk of early bankruptcy.

Suggested Citation

  • Chiang, Shu Ling & Tsai, Ming Shann, 2020. "The valuation of deposit insurance allowing for the interest rate spread and early-bankruptcy risk," The Quarterly Review of Economics and Finance, Elsevier, vol. 76(C), pages 345-356.
    • Handle: RePEc:eee:quaeco:v:76:y:2020:i:c:p:345-356
    DOI: 10.1016/j.qref.2019.09.008
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