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Purpose The purpose of this paper is to develop a theoretical framework to answer the following question: What are the consequences of sunflower behavior as well as spread behavior for how asset-liability management is administrated in a life insurance company? Design/methodology/approach This paper takes into account the following: the chief executive officer (CEO) of a life insurance company confirms the board of directors’ belief – the preference of the like of higher return relative to the dislike of higher risk; the authors call such behavior sunflower management; the life insurance policyholder is entitled to a guaranteed interest rate and a participation percentage of the company’s investment surplus; and the authors examine the optimal insurer interest margin, i.e., the spread between the loan rate and the guaranteed rate. Findings Sunflower management translates into lower utility for the CEO and makes the CEO more prudent to risk-taking at an increased insurer interest margin for the provision of life insurance contracts. The effect of the guaranteed rate on the margin is ambiguous and depends on the level of guarantee itself. An increase in the participation level decreases the CEO’s loan risk-taking at an increased margin. It is shown that a trend toward higher return like of the board’s belief produces a corresponding trend toward the CEO’s decreasing risk-taking when the return like is revealed strongly. The results indicate that sunflower management as such is an important determinant in ensuring a safe insurance system. Originality/value This is the first paper to construct a contingent claim model to evaluate the expected value of the CEO’s utility function defined in terms of the equity returns and the equity risks of a life insurance company. The model explicitly considers CEO sunflower behavior, CEO spread behavior and the limited liability of shareholders.

In this paper, we develop a contingent claim model to examine the optimal bank interest margin, i.e., the spread between the domestic loan rate and the deposit market rate of an international bank in distress. The framework is used to evaluate the cross-border lending efficiency for a bank that participates in a government capital injection program, a government intervention used in response to the 2008 financial crisis. This paper suggests that government capital injection is an appropriate way to recapitalize the distressed bank, enhancing the bank interest margin and survival probability. Nevertheless, the government capital injection lacks efficiency when the bank’s cross-border lending is high. Stringent capital regulation, suggested to prevent future crises by literature, leads to superior lending efficiency when the government capital injection is low.

Abstract:In this paper, we develop a contingent claim model to evaluate a bank's equity and liabilities that integrates the premature default risk conditions with loan rate-setting behavioral mode and multiple shadow banking activities under capital regulation. The barrier options theory of corporate security valuation is applied to the contingent claims of a bank. The barrier reports that default can occur at any time before the maturity date. We focus on a type of earning-asset portfolio, consisting of balance-sheet banking activities of loans and liquid assets and shadow banking activities of wealth management products (WMPs) and entrusted loans (ELs). The optimal bank interest margin, i.e., the spread between the loan rate and the deposit rate, is derived and analyzed. The results provide an alternative explanation for the decline in bank interest margins, which better fits the narrative evidence on bank spread behavior under capital regulation in particular during a financial crisis. Raising either WMPs or ELs leads to a transfer of wealth from equity holders to the debt holders, and hence increases the deposit insurance liabilities. We also show that the multiple shadow banking activities of WMPs and ELs captured by scope equities may produce superior return performance for the bank. Tightened capital requirements may reinforce the superior return performance by a surge in shadow banking activities that makes the bank less prudent and more prone to risk-taking at a reduced margin, thereby adversely affecting banking stability. We demonstrate that financial disturbance may be created because of the potential for shadow banking activities to spill over to regular banking activities and damage the real economy.