Monetary and Economic Studies Vol.17, No.1 / May 1999

Estimating Fair Premium Rates for Deposit Insurance Using Option Pricing Theory: An Empirical Study of Japanese Banks

Nobuyuki Oda

This paper utilizes option pricing theory to analyze bank stock prices as one method of estimating fair variable deposit insurance premium rates in accordance with individual bank default risk, and conducts empirical analyses using Japanese data. The purpose of the analyses is to discuss the framework of public organs’delegate monitoring of bank management. One of the functions of the deposit insurance system is such monitoring. The present system in the United States incorporates the subjective judgment of a bank supervisor combined with certain objective criteria for setting premium rates. There is a need to analyze the types of methodologies that might be viewed as options for adoption in Japan. To determine whether setting premium rates based on stock price information is a valid and stable approach, comparative analysis is conducted on the results of trial calculations utilizing this method versus other bank management indexes (credit ratings, etc.), and case analyses are carried out on failed banks. The conclusion is that while this method does involve a certain valuation error, it is an effective means of identifying banks with bad conditions. Moreover, the results confirm that by making adjustments for the changes in market expectations regarding the forbearance of the supervisory authorities, the accuracy of the estimates can be improved. Finally, this paper considers the impact on bank management that could be expected if this method were actually adopted.

Keywords: Deposit insurance; Variable deposit insurance rates; Option pricing theory; Stock price; Credit risk; Bankruptcy forecasting; Forbearance

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 1999 Bank of Japan All Rights Reserved.

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