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Interest Rate Risk and Capital Adequacy For Traditional Banks and Financial Intermediaries

  • J. Huston McCulloch

Traditionally, banks and financial intermediaries borrow short and lend long. This causes a risk of negative net worth (and failure, under simplifying assumptions), because the present discounted value of the assets is more volatile than that of the liabilities. This paper utilizes a new option pricing model for speculative assets whose log price relative is a symmetric stable Paretian random variable. This model is used to empirically evaluate the probability of failure and fair value of deposit insurance as a function of capital-asset ratio for a bank with demand liabilities and longer term, default-risk-free, perfectly marketable assets. The maturities used for the assets range from three months to 30 years (in order to incorporate thrift institutions). Implications for reserve requirement policy and for liability management are discussed.

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File URL: http://www.nber.org/papers/w0237.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0237.

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Date of creation: Mar 1978
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Publication status: published as McCulloch, J. Huston. "Interest Rate Risk and Capital Adequacy for Traditional Banks and Financial Intermediaries," in Risk and Capital Adequacy in Commercial Banks, ed. Sherman J. Maisel, 1981, Chicago: University of Chicago Press
Handle: RePEc:nbr:nberwo:0237
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  1. Sharpe, William F., 1978. "Bank Capital Adequacy, Deposit Insurance and Security Values," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 13(04), pages 701-718, November.
  2. J. Huston McCulloch, 1978. "The Pricing of Short-Lived Options When Price Uncertainty Is Log-Symmetric Stable," NBER Working Papers 0264, National Bureau of Economic Research, Inc.
  3. 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.
  4. William F. Sharpe, 1977. "Bank Capital Adequacy, Deposit Insurance and Security Values, Part I," NBER Working Papers 0209, National Bureau of Economic Research, Inc.
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