The misconception of the option value of deposit insurance and the efficacy of non-risk-based capital requirements in the literature on bank capital regulation

Paolo Fegatelli ()

No 46, BCL working papers from Central Bank of Luxembourg

Abstract: This study shows how the misconception of the option value of deposit insurance by Merton (1977) and its later misuse by Keeley and Furlong (1990), among others, have led some literature supporting the adoption of binding non-risk-based capital requirements to derive incorrect conclusions about their efficacy. This study further shows that what Merton defines as the option value of deposit insurance is actually a component of a bank?s limited liability option under a third-party deposit guarantee. As such, it is already included in the value of the bank?s equity capital, and the flawed definition makes the Keeley-Furlong model internally incoherent.

Keywords: Capital requirements; Credit risk; Deposit insurance; Prudential regulation; Portfolio approach (search for similar items in EconPapers)
JEL-codes: G11 G21 G28 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2010-07
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Published in the Journal of Financial Stability, 2010, 6(2):79-84

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Persistent link: https://EconPapers.repec.org/RePEc:bcl:bclwop:bclwp046

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