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The effect of subordinated debt and surety bonds on banks' cost of capital and on the value of federal deposit insurance

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  • William P. Osterberg
  • James B. Thomson

Abstract

This paper examines two proposals to correct the risk-taking incentives embedded in the current deposit insurance system and to provide protection to the deposit insurance fund. the first would require banks to issue subordinated debt, and the second would require bank stockholders to post surety bonds. We use the cash-flow version of the Capital Asset Pricing Model to show how each proposal would affect the values and rates of return on uninsured deposits and equity. We then indicate the impact that each proposal would have on the values of the Federal Deposit insurance Corporation claim and on the bank, emphasizing the role of deposit insurance pricing.

Suggested Citation

  • William P. Osterberg & James B. Thomson, 1990. "The effect of subordinated debt and surety bonds on banks' cost of capital and on the value of federal deposit insurance," Working Paper 9012, Federal Reserve Bank of Cleveland.
  • Handle: RePEc:fip:fedcwp:9012
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    References listed on IDEAS

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    1. Herbert L. Baer, 1985. "Private prices, public insurance: The pricing of federal deposit insurance," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 45-57.
    2. Edward J. Kane, 1987. "No Room for Weak Links in the Chain of Deposit Insurance Reform," NBER Working Papers 2317, National Bureau of Economic Research, Inc.
    3. Gorton, Gary & Santomero, Anthony M, 1990. "Market Discipline and Bank Subordinated Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(1), pages 119-128, February.
    4. Edward J. Kane, 1989. "How Incentive-Incompatible Deposit-Insurance Funds Fail," NBER Working Papers 2836, National Bureau of Economic Research, Inc.
    5. Herbert L. Baer & Elijah Brewer, 1986. "Uninsured deposits as a source of market discipline: some new evidence," Economic Perspectives, Federal Reserve Bank of Chicago, issue Sep, pages 23-31.
    6. Merton, Robert C, 1978. "On the Cost of Deposit Insurance When There Are Surveillance Costs," The Journal of Business, University of Chicago Press, vol. 51(3), pages 439-452, July.
    7. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    8. Avery, Robert B & Belton, Terrence M & Goldberg, Michael A, 1988. "Market Discipline in Regulating Bank Risk: New Evidence from the Capital Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 597-610, November.
    9. Edward J. Kane, 1985. "The Gathering Crisis in Federal Deposit Insurance," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262611856, January.
    10. Pennacchi, George G, 1987. "A Reexamination of the Over- (or Under-) Pricing of Deposit Insurance," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(3), pages 340-360, August.
    11. William P. Osterberg & James B. Thomson, 1987. "Deposit insurance and the cost of capital," Working Paper 8714, Federal Reserve Bank of Cleveland.
    12. James B. Thomson, 1987. "FSLIC forbearances to stockholders and the value of savings and loan shares," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 26-35.
    13. Chen, Andrew H, 1978. "Recent Developments in the Cost of Debt Capital," Journal of Finance, American Finance Association, vol. 33(3), pages 863-877, June.
    14. Mark J. Flannery, 1989. "Pricing deposit insurance when the insurer measures risk with error," Proceedings 229, Federal Reserve Bank of Chicago.
    15. Buser, Stephen A & Chen, Andrew H & Kane, Edward J, 1981. "Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital," Journal of Finance, American Finance Association, vol. 36(1), pages 51-60, March.
    16. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-895, September.
    17. Hannan, Timothy H & Hanweck, Gerald A, 1988. "Bank Insolvency Risk and the Market for Large Certificates of Deposit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 203-211, May.
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    Keywords

    Deposit insurance ; Bank capital;

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