Credit risk and the deposit insurance premium: a note

Abstract

Previous research on market-based evaluation of deposit insurance premia has modeled the bank as a corporate firm with risky assets and insured liabilities. No attempt was made to analyze explicitly the risk characteristics of bank assets. The purpose of this note is to model bank lending explicitly and calculate loan-risk sensitive insurance premia. The lending function of banks creates the need to model equity as a 'capped' call option. A simulation exercise shows that market-based estimates of deposit insurance premium which ignore the cap lead to significant underestimation. © 2001 Elsevier Science Inc. All rights reserved.