David H. Pyle

Safety-First and Expected Utility Maximization in Mean-Standard Deviation Portfolio Analysis

Publisher Summary The various safety-first criteria lead to optimization of expressions involving the mean and standard deviation. This chapter presents a comparison of this justification of mean-standard deviation analysis with the more conventional approach based on expected utility maximization. In the absence of a riskless asset, a correspondence can be established between the safety-first criterion and expected utility maximization when that maximization results in concave indifference curves in the mean-standard deviation space and if a riskless asset is available, then except in one special case, the safety-first criterion does not lead to the traditional liquidity preference behavior. The chapter presents a graphical demonstration of the relationship between mean-standard deviation analysis based on expected utility maximization and mean-standard deviation analysis based on the safety-first principle for the no riskless asset case. The correspondence between the expected utility and the safety-first approaches to mean-standard deviation analysis breaks down seriously when the investor has the opportunity of holding a risk-less asset.

Capital regulation and deposit insurance

Abstract A model of deposit insurance in which the bank closure rule can systematically deviate from the economic insolvency condition used in earlier models is developed. Simulation of that model for plausible parameter values suggests that the failure to close banks on a timely basis has a profound effect in increasing the insurers liability. The implications of these results for capital regulation are discussed.

Liquidation Costs and Risk- Based Bank Capital

Bank capital rules which do not recognize audit costs, liquidation costs and portfolio diversification can seriously underestimate actuarially fair capital requirements. If depositors do not have access to low cost alternatives, the effect of higher requirements can be imposed on them. Otherwise, they need absorb only costs associated with minimum-risk, minimum-cost assets. If borrowers have direct access to financial markets or can borrow from uninsured, less highly levered institutions, insured banks facing a fair risk-based capital requirement and fixed premium cannot attract them. A schedule of required capital and insurance premium pairs would allow banks to retain investment flexibility.

Bank Risk Management: Theory

Not too many years ago, the then Chairman of the U.S. House Banking Committee told me it was out of the question to require banks and savings and loans to mark their assets to market. Would anyone responsible for financial regulatory oversight have the temerity to be similarly dismissive today? I suspect the answer is yes. However, the increased attention that formal, scientific appraisal of bank risk has received since then is gratifying to most financial economists. The fact that contemporary bank-risk management employs many of the important theoretical and methodological advances in our field is a source of collective pride. My role on this program is to outline some of the theoretical underpinnings of contemporary bank-risk management. I shall begin with a discussion of why bank-risk management is needed. Then I shall provide some of the theoretical bases for bank-risk management with an emphasis on market and credit risks.

Chapter 33 The U.S. savings and loan crisis

Publisher Summary This chapter discusses the U.S. Savings and Loan crisis of the late 1980s and early 1990s. Between 1980 and March 31, 1992, federal agencies disposed of over 1100 insolvent Savings and Loan (S&L) institutions and— as of March 31, 1992— an additional 408 S&Ls holding 29% of the industrys assets were classified as troubled. The crisis was caused and exacerbated by (1) a flaw in the structure of S&Ls that predisposed them to economic insolvency given rising interest rates, (2) the use of an incentive-incompatible deposit insurance scheme and its exploitation by S&Ls (especially permanent stock companies) that became poorly capitalized as a result of (1), and (3) legislative and regulatory actions to avoid recognizing the economic insolvency of numerous firms and the general under-capitalization of the industry, actions which in many cases were dysfunctional in the context of the existing deposit insurance contract. Evidence on the determinants of efficiency and insolvency in S&Ls isstrikingly supportive of this thesis and the option-theoretic model used in its development.