Abstract
We model deposit insurance as a European put option on the value of the bank in which bank assets follow a displaced lognormal diffusion process. We derive closed-form solutions for the value of the bank for bank equity holders, depositors, and the deposit insurer under three deposit insurance schemes that are representative of deposit insurance around the world. Doing so allows us to compute actuarially fair insurance premiums that are risk adjusted, include market information, and explicitly account for the diverging effects of safe versus risky assets on bank risk. We illustrate the use of the model on a sample of 212 U.S. bank holding companies and discuss practical considerations for implementing the model. Implications for our model as a market-based, early indicator of bank risk are considered.
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