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

Abstract

a b s t r a c tThis 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.

Bank Liquidity Regulation and Risk

“…An essential feature of Basel III is the addition of liquidity requirements. While there is an extensive literature which investigates the impact of capital regulation on bank risk (Koehn and Santomero, 1980;Kim and Santomero, 1988;Gjerde and Semmen, 1995;Fegatelli 2010;Anginer et al, 2021, among others), to our knowledge this study is among the first to investigate empirically how liquidity regulation affects bank risk.…”