Deposit Insurance, Capital Adequacy Requirements and Interest Rate Dynamics

Gordon V., John M., Arun J. Karels Geppert Prakash

Journal of Business Finance & Accounting, 1997, vol. 24, issue 9‐10, 1311-1330

Abstract: This paper examines the long run interaction among deposit insurance, bank deposit rates and capital adequacy requirements. Using analysis similar to the price discrimination model of Lott and Roberts (1991) we find that a competitive environment among banks would link the spread between insured and uninsured deposit rates to the size of the insurance premium. We also find that banks that choose to operate at the regulatory minimum capital level, would increase asset risk with increased capital requirements if (1) the implicit interest paid to insured and uninsured depositors is equally sensitive to changes in risk and capital adequacy and (2) the insurance premium is independent of the level of risk and capital adequacy. Under the present risk‐based premium structure, asset risk has the potential to decline when the regulatory agency raises capital requirements. Finally, we examine the time series behavior of insured and uninsured interest rates to see if it is consistent with our theoretical model. We find that insured and uninsured rates, along with deposit insurance premiums, are cointegrated series as suggested by our model.

Date: 1997
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