C.W. Sealey

Fixed-rate deposit insurance and risk-shifting behavior at commercial banks

Abstract Fixed-rate deposit insurance is thought to provide banks with an incentive to shift risk to the FDIC, thereby expropriating wealth. Banks can achieve these wealth transfers by increasing their overall risk and thus increasing the actuarial value of the deposit insurance. In this paper, the risk-shifting hypothesis is tested on a sample of US banks. An option-based methodology is used to price each banks actuarial liability to the FDIC. Statistical tests are then conducted to determine if banks have been successful in manipulating risk in such a way as to increase these liabilities. The results suggest that risk-shifting is not widespread, although there are notable exceptions.

Forbearance, deposit insurance pricing, and incentive compatible bank regulation

Abstract This paper examines the incentive compatible role of regulatory forbearance policy in the context of optimal bank regulation under moral hazard. We show that, when a banks asset portfolio returns have market risk, the regulator can influence the banks choice of ex ante risk by delaying the closure of an insolvent bank. The optimal closure policy involves co-ordinating the closure decision with market-wide performance. Such a policy may significantly alleviate the banks ex ante risk-shifting problem. Furthermore, even fixed-rate deposit insurance can be optimal when combined with a sound forbearance policy and a minimum capital standard.

Deposit insurance and bank interest rate risk: Pricing and regulatory implications

Abstract The linkage between the interest rate risk exposure of banks and the liabilities of a deposit insuring agency is not well understood. In this paper, a model is developed to evaluate the interest rate risk exposure of both deposit taking institutions and deposit insuring agents when bank equity has limited liability and interest rates are stochastic. Based on a sample of U.S. banks, empirical results are presented for the interest rate risk exposure of banks and its impact on the liabilities of the FDIC.

Portfolio separation for stockholder owned depository financial intermediaries

Abstract The conditions leading to separation of asset composition and financing decisions for depository financial intermediaries have received considerable attention in the literature. Although research to date provides useful insights into the issue of separation, none analyze separation from the point of view of shareholder approval. In this paper a single-period model of investor behavior is developed and analyzed based on market equilibrium. The impetus for the existence of intermediaries is random cash payments of investors and liquidation costs. The conditions for shareholder unanimity and optimal rules for intermediary decisions are derived. The optimality conditions are then analyzed for separation.

Spanning with Index Options

Current literature stresses that efficient funds do not exist when asset returns are continuously distributed. This paper shows that the existence of efficient funds can be restored if security returns are generated by a linear factor model.

Some implications of traded options on the pricing of the underlying stock

Abstract In a large asset market where the equilibrium APT holds and stock options are priced by the Black-Scholes model, the expected return of the stock must equal the risk-free rate. This conclusion is due to the fact that a zero-beta stock-option hedge will not have a risk-free rate of return unless the expected return of the stock equals the risk-free rate. If one accepts the equilibrium APT and the Black-Scholes option pricing model as good approximations, the result provides a plausible explanation for some recent anomalous empirical findings.

Can Delegating Bank Regulation to Market Forces Really Work

A major theme in the literature on bank regulation is that greater reliance on market forces can mitigate the moral hazard problem inherent in government sponsored deposit insurance. Specific proposals to impose greater market discipline on banks include minimum requirements on (1) uninsured subordinated debt financing (either fixed-term or with option-type features), and (2) private coinsurance on deposits. Both proposals amount to delegating the responsibility for bank regulation to various private sector claimholders. The results suggest that such delegation (with or without claims that include option-type features) may be ineffective in lowering bank risk, at least within the present regulatory and institutional framework. Alternative mechanisms exist that can mitigate the moral hazard problem; however, it may be necessary for the regulator/deposit insurer to be an integral part of the solution.

Asymmetric information and a theory of compensating balances

This paper derives an economic justification for the existence of compensating balance requirements using an equilibrium model of asymmetric information. Because bank profitability depends upon the probability distribution of a borrowers future cash requirements, and assuming this distribution is known by the borrower but not by the bank, compensating balance requirements can be used by the bank as a screen to distinguish among borrowers. Compensating balances are shown to exist without invoking assumptions of monopoly banks or non-maximizing behavior, and these balances need not be explained as a method of indirect payment for bank services.

A reply to “a note on the implications of traded options on the pricing of the underlying stock”

Abstract The comments by Berglund and Ringbom (1984) on our paper are incorrect. Their mistake arises from their failure to recognize that one error term in endogenously derived as a result of projection, and hence cannot be given an arbitrary value.