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Pricing Deposit Insurance in the United Kingdom

Author

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  • David Maude
  • William Perraudin

Abstract

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.

Suggested Citation

  • David Maude & William Perraudin, 1995. "Pricing Deposit Insurance in the United Kingdom," Bank of England working papers 29, Bank of England.
  • Handle: RePEc:boe:boeewp:29
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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1995/wp29.pdf
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    References listed on IDEAS

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    1. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-556, June.
    2. Fries Steven & Mason Robin & Perraudin William, 1993. "Evaluating Deposit Insurance for Japanese Banks," Journal of the Japanese and International Economies, Elsevier, vol. 7(4), pages 356-386, December.
    3. Calomiris, Charles W., 1990. "Is Deposit Insurance Necessary? A Historical Perspective," The Journal of Economic History, Cambridge University Press, vol. 50(02), pages 283-295, June.
    4. R. Dan Brumbaugh, JR. & Andrew S. Carron & Robert E. Litan, 1989. "Cleaning Up the Depository Institutions Mess," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 20(1), pages 243-296.
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    Cited by:

    1. Rossana Díaz Narváez & Jean François Clévy, 2006. "Determinantes del spread bancario en Nicaragua: un análisis econométrico," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 185-216, abril-jun.
    2. Omar A. Mendoza Lugo, 2006. "Las asimetrías del pass-through en Venezuela," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 151-183, abril-jun.
    3. César Calderón & Rodrigo Fuentes, 2006. "¿Cuánto explican las reformas y la calidad de las instituciones del crecimiento chileno?: una comparación internacional," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 119-149, abril-jun.
    4. Juan Carlos Castañeda F. & Óscar Leonel Herrera V. & Carlos Antonio Alvarado M., 2006. "Midiendo el riesgo bancario en Guatemala: un enfoque de opciones," Monetaria, Centro de Estudios Monetarios Latinoamericanos, vol. 0(2), pages 217-234, abril-jun.

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