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Bank deposit insurance and business cycles: controlling the volatility of risk-based premiums

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  • George Pennacchi

Abstract

Proposals to make deposit insurance risk-based need to consider how premiums would fluctuate over the business cycle. This paper derives a new deposit insurance contract that has the following three features: 1) it is fairly priced in the sense that the insurer conveys no subsidy to the bank; 2) the insurance rate can be made as stable as desired by lengthening the "average" maturity of the contract; 3) the rate can be frequently updated as new information regarding the bank's financial condition is obtained. These characteristics are achieved with a contract that is a combination of several long-term ones whose contract intervals partially overlap. Relative to a standard, short-term contract, this "moving average" contract reduces the volatility of a bank's insurance rates and avoids payment of excessively high premiums during times of financial distress. ; Estimates of fair insurance rates under such a contract are presented for 42 banks based on data over the period 1987 to 1996. While lengthening the average maturity of the contract reduces the volatility of insurance rates, it also increases the average level of rates since the insurer requires a greater premium for systemic risk. The paper also finds that the distribution of fair insurance rates across banks is skewed, with most banks paying relatively low rates and a small minority of banks paying much higher ones.

Suggested Citation

  • George Pennacchi, 2002. "Bank deposit insurance and business cycles: controlling the volatility of risk-based premiums," Conference Series ; [Proceedings], Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbcp:y:2002:x:3
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    File URL: http://www.bostonfed.org/bankinfo/conevent/slowdown/pennacchi.pdf
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    References listed on IDEAS

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    1. G. G. Garcia, 2000. "Deposit Insurance; Actual and Good Practices," IMF Occasional Papers 197, International Monetary Fund.
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    Cited by:

    1. Andrew Kuritzkes & Til Schuermann & Scott Weiner, 2005. "Deposit Insurance and Risk Management of the U.S. Banking System: What is the Loss Distribution Faced by the FDIC?," Journal of Financial Services Research, Springer;Western Finance Association, vol. 27(3), pages 217-242, September.
    2. Michael Falkenheim & George Pennacchi, 2003. "The Cost of Deposit Insurance for Privately Held Banks: A Market Comparable Approach," Journal of Financial Services Research, Springer;Western Finance Association, vol. 24(2), pages 121-148, October.

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    Keywords

    Risk management ; Deposit insurance;

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