Pricing Deposit Insurance in the United Kingdom

This paper outlines a method for estimating the value of deposit insurance based on option pricing theory. It follows the approach of Merton who viewed deposit insurance as, essentially, a put option on the value of the bank's assets. Three models are analysed, each embodying a different assumption about the bank closure rule. First, it is assumed that closures occur on given (annual) audit dates if the banks assets are less than its total insured deposits. Second, an endogenous closure rule is considered where the authorities allow the ailing bank to continue operating as long as the shareholders are willing to meet its operating losses. Third, an extension of model two is analysed where the authorities themselves can subsidise the ailing bank, thus postponing liquidation. The paper then estimates the value of deposit insurance in these three models using share price data from eight large UK banks. For each model the deposit insurance premiums vary significantly across banks and across models (though bank rankings across models was relatively stable). The paper concludes that option pricing models don't provide a useful guide for setting the level of deposit insurance premiums. They could, however, give insights as to the relative cost of deposit insurance across banks.