The Asset Flexibility Option and the Value of Deposit Insurance

Research in Finance, Vol. 13, 1995

Bank Structure and Competition: Rebuilding Banking, Federal Reserve Bank of Chicago, pp. 153-176, 1991

Posted: 16 Jun 2003

See all articles by Peter H. Ritchken

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance

Ramon P. DeGennaro

University of Tennessee, Knoxville - Department of Finance

James B. Thomson

University of Akron

Anlong Li

KL Capital

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

Suggested Citation

Ritchken, Peter H. and DeGennaro, Ramon P. and Thomson, James B. and Li, Anlong, The Asset Flexibility Option and the Value of Deposit Insurance. Research in Finance, Vol. 13, 1995; Bank Structure and Competition: Rebuilding Banking, Federal Reserve Bank of Chicago, pp. 153-176, 1991. Available at SSRN: https://ssrn.com/abstract=411321

Peter H. Ritchken

Case Western Reserve University - Department of Banking & Finance ( email )

10900 Euclid Ave.
Cleveland, OH 44106-7235
United States
216-368-3849 (Phone)
216-368-4776 (Fax)

Ramon P. DeGennaro (Contact Author)

University of Tennessee, Knoxville - Department of Finance ( email )

423 Stokely Management Center
Knoxville, TN 37996
United States
865-974-1726 (Phone)
865-974-1716 (Fax)

James B. Thomson

University of Akron ( email )

Akron, OH 44325-4803
United States

Anlong Li

KL Capital ( email )

141 Jackson Blvd
Suite 1650
Chcago, IL 60604
United States

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