The Behavior of Banks under the Deposit Insurance and Capital Requirements
Deposit insurance and capital requirements are two focuses in banking literature. Many researchers criticize these two important schemes using moral hazard theory: Under the protection of the deposit insurance, banks have incentive to take deposits as much as they can for some debt-favor reasons such as tax deduction on interest payment, and let the FDIC pay for the deposits if it turns out banks do not have enough capital to pay the deposits back. One the other hand, banks also have incentive to take riskier investment in hope of having higher returns. When capital requirements are imposed, insured banks may shift priced risks to unpriced risks. Therefore, capital requirements actually will lead banks to take more risks, and hence lead to higher probability of bank failure. However, this criticism does not consider the implicit costs of bankruptcy. If a bank is bankrupt, it will lose the benefit of deposit insurance. Moreover, it will lose the possible future earnings. In this paper, I take into account the implicit costs of bankruptcy, and investigate how banks react to the fixed and risk-based capital requirements under deposit insurance. In my basic model, I adopt one factor option pricing model and find a closed-form solution for bank equity in terms of asset-to-debt ratio. In my extension model, I relax the assumption of constant interest rate in the basic model. Thus, the uncertainty of bank equity comes from two sources: capital ratio and interest rate. I adopt a general form of term structure and find the numerical solution for the bank equity value as a function of both asset-to-debt ratio and interest rate. Through the stochastic term structure, interest rate risk is also involved. The results show that banks actually prefer to use more capital even there are no capital requirements. Moreover, banks tend to take lower risk instead of high risk no matter there are capital requirements or not, if they are solvent. However, for insolvent banks, they may take riskier investment. Under the risk-based capital requirements, banks would prefer lower capital requirements by taking lower risk. Lastly, capital requirements only have impact on banks with low capital. For those well capitalized banks, capital requirements will not affect their behavior too much.
|Date of creation:||11 Nov 2005|
|Date of revision:|
|Contact details of provider:|| Web page: http://comp-econ.org/|
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
- Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
- 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.
- Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- William F. Sharpe, 1977. "Bank Capital Adequacy, Deposit Insurance and Security Values, Part I," NBER Working Papers 0209, National Bureau of Economic Research, Inc.
- Brennan, Michael J & Schwartz, Edwardo S, 1978. "Corporate Income Taxes, Valuation, and the Problem of Optimal Capital Structure," The Journal of Business, University of Chicago Press, vol. 51(1), pages 103-14, January.
- Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-60, November.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
- Hayne E. Leland., 1994.
"Corporate Debt Value, Bond Covenants, and Optimal Capital Structure,"
Research Program in Finance Working Papers
RPF-233, University of California at Berkeley.
- Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
- Dothan, Uri & Williams, Joseph, 1980. "Banks, bankruptcy, and public regulation," Journal of Banking & Finance, Elsevier, vol. 4(1), pages 65-87, March.
- Merton, Robert C., 1997.
"Applications of Option-Pricing Theory: Twenty-Five Years Later,"
Nobel Prize in Economics documents
1997-1, Nobel Prize Committee.
- Merton, Robert C, 1998. "Applications of Option-Pricing Theory: Twenty-Five Years Later," American Economic Review, American Economic Association, vol. 88(3), pages 323-49, June.
- Keeley, Michael C. & Furlong, Frederick T., 1990. "A reexamination of mean-variance analysis of bank capital regulation," Journal of Banking & Finance, Elsevier, vol. 14(1), pages 69-84, March.
- Kareken, John H & Wallace, Neil, 1978. "Deposit Insurance and Bank Regulation: A Partial-Equilibrium Exposition," The Journal of Business, University of Chicago Press, vol. 51(3), pages 413-38, July.
- Furlong, Frederick T. & Keeley, Michael C., 1989. "Capital regulation and bank risk-taking: A note," Journal of Banking & Finance, Elsevier, vol. 13(6), pages 883-891, December.
- Koehn, Michael & Santomero, Anthony M, 1980. " Regulation of Bank Capital and Portfolio Risk," Journal of Finance, American Finance Association, vol. 35(5), pages 1235-44, December.
- Frederick T. Furlong & Michael C. Keeley, 1991. "Capital regulation and bank risk-taking: a note (reprinted from Journal of Banking and Finance)," Economic Review, Federal Reserve Bank of San Francisco, issue Sum, pages 34-39.
When requesting a correction, please mention this item's handle: RePEc:sce:scecf5:407. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)
If references are entirely missing, you can add them using this form.