Market Pricing of Deposit Insurance

The valuation of a firm’s investment opportunities: a reduced form credit risk perspective

“…The empirical default intensity is obtained using the hazard rate model contained in Duffie et al (2003). The martingale intensity is obtained by scaling up the empirical intensity by various values of the market price of default risk, i.e., risk-neutral intensity = 5 and 10 times the empirical intensity (see Duffie et al 2003). For the recovery rate, we use Moody's research report (1998) on default and recovery rates.…”

Modelling Deposit Insurance Scheme Losses in a Basel 2 Framework

“…This approach relies on structural credit risk models to derive the banks' probability of default and, typically, on simulation-based methods to quantify the DIS loss distribution (Kuritzkes et al 2005;Sironi et al 2004). The second methodology, which is less common in the DIS literature, adopts instead a reduced-form model, drawn from the pricing of fixed-income securities under default risk, adjusted to be tractable for banks without market debts (Duffie et al 2003). …”

“…In the structural approach, default is identified as the event occurring when the market value of the bank's assets falls below a certain threshold, generally determined by the value of the bank's liabilities. Conversely, when the reduced form model is used, as pointed out by Duffie et al (2003), default is defined as a stopping time the intensity of which depends on covariates such as leverage, credit rating or macroeconomic conditions. An application of the first methodology to deposit insurance is provided by Kuritzkes et al (2005), for the US context.…”

“…Their modelling framework explicitly takes into account the liability structure of banks, by distinguishing insured and uninsured deposits from senior secured debts, and introduces the correlation between PD and LGD as a determinant of deposit insurance premia. 2 Duffie et al (2003) present an application of reduced form models to DIS, inspired by the pricing of fixed-income securities subject to default risk. The fair-market insurance rate for a given bank is approximated as the bank's short term credit spread times the ratio of the insurer expected loss at failure per dollar of insured deposits to the bond investor's expected loss at failure per dollar of principal.…”

“…The fair-market insurance rate for a given bank is approximated as the bank's short term credit spread times the ratio of the insurer expected loss at failure per dollar of insured deposits to the bond investor's expected loss at failure per dollar of principal. Furthermore, to overcome the possibility that financial institutions do not present market debts in their capital structure, Duffie et al (2003) propose an alternative methodology based on a logit model of the bank's default probability.…”