Risk-Based Deposit Insurance: An Application to Thailand

Abstract

This paper investigates the application of option pricing to calculate the premium of deposit insurance in Thailand during the 1992-1996 period. In addition to applying the traditional Black- Scholes model, the barrier model of Boyle and Lee (1994) is examined. The barrier model takes the management (owners) action into account: the management (owners) may have a strong incentive to increase the volatility of the bank's assets, since this action increases the value of their equity. As suggested by the stylized evidence, most financial institutions in Thailand were "family owned", and there was inadequate corporate governance to prevent the incentive problems. The barrier model seems to fit the description of financial institutions in Thailand. The overall results show that the deposit insurance premiums of failed financial institutions are higher than the premiums of non-failed institutions. The evidence suggests that the option framework seems to be appropriate for pricing the premium: higher risk institutions pay higher insurance premiums. The results also show that the risk-based insurance premiums vary across time and on average are less than the premiums charged by the Financial Institutions Development Fund (FIDF).