The effect of subordinated debt and surety bonds on the cost of capital for banks and the value of federal deposit insurance

Abstract

This paper examines two proposals to reduce the subsidy to risk-taking embedded in the current deposit insurance system and to protect the deposit insurance fund. The two proposals are (1) requiring banks to issue subordinated debt, and (2) requiring bank stockholders to post surety bonds. We use the cash-flow version of the CAPM [Chen (1978)] to show how each proposal affects the values and rates of return on uninsured deposits and equity. We also find that only if deposit insurance is mispriced can either affect the values of the FDIC claim and the bank.