Market-based, risk-adjusted examination schedules for depository institutions

Abstract

Among deposit insurance reforms considered by economists and policymakers have been prompt resolution of problem institutions, risk-adjusted deposit insurance premiums and risk-adjusted capital requirements. Some economists have further suggested that risk-adjusted deposit insurance premiums or capital ratios be calculated by applying option pricing models to stock market data. Alternatively, the option methodology could be used to establish a risk-based examination schedule whereby riskier banks would be examined on a more frequent basis. Such an examination schedule would be consistent with prompt resolution strategies since it would relate the frequency of examination and closeness of supervision to banks' riskness. This paper demonstrates how a risk-adjusted examination schedule could be derived. The paper also considers alternatives to the assumptions regarding examination policies made in standard applications of the option model, which may not be valid for the sample periods previously used. It discusses potential resulting biases and ways to mitigate their effects.