The Asset Flexibility Option and the Value of Deposit Insurance

Abstract:     
Optimal equityholder decisions involve trade-offs between risk-minimizing strategies, which reduce the likelihood of losing the charter, and risk-maximizing strategies, which exploit the insured-deposit base. When banks cannot respond dynamically to market information, we have seen that the bank optimally selects extreme positions.

Given any flat-rate insurance scheme, incentives exist for firms to revise their portfolios dynamically in response to market information. These dynamic revisions are aimed at exploiting the insured-deposit base more fully, thereby mitigating the likelihood of bankruptcy. The additional value captured by equityholders responding dynamically to jointly maximize the charter value and the deposit insurance subsidy, beyond the static value, is captured in the value of the asset flexibility option.

In the presence of the asset flexibility option, portfolio decisions may not be extreme and interior solutions may be optimal. The likelihood of interior solutions may increase as the number of portfolio revision opportunities expands. Moreover, the value and the insured deposit base, provided at a flat rate, increases with the number of portfolio revision opportunities.

Our results suggest that the value of flat-rate deposit insurance established by static models underestimates the true value because it completely ignores the flexibility option. The impact of the flexibility option can be significant and, if ignored, may lead to understating the value of deposit insurance by as much as 40 percent. The results suggest that bank regulators should factor the flexibility option into any risk-adjusted capital guidelines and also into closure policies.

Keywords: deposit insurance, regulation, banks, options

JEL Classification: G21, G28

Accepted Paper Series