Risk Based Pricing of Deposit Insurance: Empirical Estimation of Commercial Banks of India

XI Capital Markets Conference, 21-22 December 2012, Indian Institute of Capital Markets (UTIICM)

17 Pages Posted: 2 May 2013

See all articles by Mohit Jalan

Mohit Jalan

SBI Capital Markets Ltd

H. K. Pradhan

XLRI Jamshedpur

Date Written: December 21, 2012

Abstract

Option theory based credit risk models are being used by international banks to evaluate the default risk of their loan portfolios. A number of empirical studies have been conducted using the options theory approach to price deposit insurance; viewed as a loan guarantee, designed to protect the interest of retail depositors in the event of bank failures. This study attempts to evaluate the credit risk of large Indian banks; and subsequently attempts to price the deposit insurance premium based on the risk characteristics of banks as perceives by the market. Using both balance sheet and equity market data for a sample of 40 listed Indian banks for the period 2000-2010, this study applies a credit value at risk model to estimate individual default risks for the Deposit Insurance and Credit Guarantee Corporation (DICGC), the Indian deposit insurance agency. We question the flat deposit insurance premium structure in practice in India, where the banks pay premium in every six months which is 5 basis points of their overall outstanding deposits, and argue that this be determined by the risk characteristics of deposit accepting banks. The empirical analysis allows us to estimate the loss probability distribution of the DICGC exposures which in turn can be used to: (i) evaluate the DICGC fund adequacy; (ii) estimate the marginal contribution to the whole portfolio risk of an individual insured bank; (iii) test an alternative risk-adjusted deposit insurance pricing scheme to the more traditional one based on option pricing models. The study uses a methodology as provided by Duan, Moreau, and Sealey(Fixed-Rate Deposit Insurance and Risk-Shifting Behavior at Commercial Banks, Journal of Banking and Finance, 1992), which is based on the seminal work of Robert C Merton(An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory, Journal of Banking and Finance, 1977). The results of the present study reveal that large banks are paying a higher premium compare to their individual riskiness. These significant differences make it even more important the introduction of a risk-based pricing system for deposit insurance in India. Such differences reflect both differences in the banks’ individual risk profiles and the higher impact that the exposures to larger banks present on the risk profile of the DICGC portfolio. We assert that the premium structure should depend upon the total expected loss of a particular bank.

Keywords: Pricing Deposit Insurance, Option Theory Applications

Suggested Citation

Jalan, Mohit and Pradhan, H. K., Risk Based Pricing of Deposit Insurance: Empirical Estimation of Commercial Banks of India (December 21, 2012). XI Capital Markets Conference, 21-22 December 2012, Indian Institute of Capital Markets (UTIICM) . Available at SSRN: https://ssrn.com/abstract=2255474 or http://dx.doi.org/10.2139/ssrn.2255474

Mohit Jalan (Contact Author)

SBI Capital Markets Ltd ( email )

202, Maker Tower E
Cuffe Parade-Colaba
Mumbai, 400005
India

H. K. Pradhan

XLRI Jamshedpur ( email )

C H Area (E)
Jamshedpur, Jharkhand 831001
India
+091 657 222 5506 (Phone)
+091 657 222 7814 (Fax)

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