pricing risk adjusted deposit insurance an option based model this paper presents a methodology for arriving at empirical estimates of deposit insurance premiums from market data by using isomorphic relationships betweeen equity and a call option and insurance and a put option the data utilizes the market value of equity to solve for the asset value and its volatility market perceptions of fdic bailout policies are explicitly modeled so as to eliminate the bias in inverted values of assets and their volatility sensitivity analyses are performed to show that rank orderings based on premiums are robust to changes in specification thus facilitating allocation of aggregate premium across banks while economists have long argued in favor of risk adjusted deposit insurance as both more equitable and more efficient than the current system of flatrate premiums various recent developments have further contributed to an increasing dissatisfaction with the current system first both the banking industry and the government seem to be tending to the view that deregulation of the banking industry would be necessary in order to meet more sophisticated future demands on the industry as well as desirable as a policy means of stimulating greater competition among banks moreover a sudden rise in the incidence of bank failures 1 and the vulnerability of the u s banks to the socalled international debt crisis have served to bring to the fore concern about the health of the banking industry in the absence of deposit insurance riskier banks will be able to attract deposits only at higher rates and these higher costs of funding serve as built in market regulated incentives to limit excessive risk taking by banks as introduction of deposit insurance makes deposits equally risk free across banks these incentives disappear and regulation and close supervision of the banking industry must necessarily replace them as deterrents to excessive risk taking thus when insurance is offered at a flat premium regulation is designed to ensure that the risk posed to the insurer both asset and financial risk is appropriately uniform

firm size and economic growth abstract in a sample of more than 700 us cities the average size of manufacturing and retail firms is negatively and robustly associated with subsequent growth rates of median household income wholesale and service firms display less consistent associations

a critical review of contagion risk in banking the recent financial crisis has focused the attention of scholars and policymakers on how to improve financial stability through better macro prudential regulation and supervision in this paper we compare the existing theoretical and empirical literature on contagion through the banking system it is argued that the structure of the interbank market the size of banks the linkages among them the level of correlation of their investments and the transparency of the regulator are key factors in determining the possibility of contagion we discuss the different findings and present avenues for future research

deposit insurance reform what are the issues and what needs to be fixed abstract the current problems in the commercial banking industry have led to widespread calls for reform of the deposit insurance contract on the grounds that it promotes moral hazard we review the empirical evidence for the significance of moral hazard as an important cause of the present crisis we then evaluate various reform proposals grouped into two broad classes proposals that seek to impose greater discipline on bank stockholders and proposals to increase the disciplinary role of bank debtholders finally we identify some issues that have received inadequate attention in the literature on bank regulation

empirical patterns of firm growth and r d investment a quality ladder model interpretation we present a partial equilibrium model of endogenous firm growth with r d investment and stochastic innovation as the engines of growth drawing on the quality ladder models in the macro growth literature and the literature on patent races and the discrete choice models of product differentiation the model fits a number of empirical patterns well including i a skewed size distribution of firms with persistent differences in firm sizes ii firm growth independent of firm size as stated in the so called gibrat s law and iii r d investment proportional to sales

the limitations of market value accounting and a more realistic alternative abstract market value accounting mva might improve market and regulatory discipline on financial institutions unfortunately there are serious conceptual measurement and incentive problems with implementing mva that have not received significant attention these problems are suggested by the theory of asymmetric information and the role intermediaries play in solving information and monitoring problems after analyzing the problems with mva we develop an alternative approach that applies mva principles where they are most feasible and uses a statistical procedure where asymmetric information problems make mva particularly problematic an empirical analysis suggests that this procedure may substantially improve the distribution of regulatory discipline

democracy and national economic performance the preference for stability appear to arise because democracies ameliorate the effects of social cleavages another mechanism that might explain democratic stability when growth and volatility are jointly examined democracies reveal highly favorable economic results oes democracy affect national economic performance and if so how no question is more central to the study of political economics almost all previous work on democracy and economic performance has focused exclusively on growth rates with contradictory and confusing results in this article we argue that to reveal the impact of democratic institutions on economic performance scholars must consider two dimensions of economic performance growth rate and volatility we begin with a novel hypothesis economic policy in democracy is risk avoiding relative to policy in nondemocracies 1 because voters are riskaverse they penalize incumbent governments for economic volatility and democratic governments respond accordingly in nondemocracies we posit that elites are more likely to seek risk that voters would reject consequently autocracies produce systematically more economic volatility than

risk shifting incentives of depository institutions a new perspective on federal deposit insurance reform abstract we characterize the risk shifting incentives of a depository institution as arising fundamentally from the existence of limited liability and the associated convex payoff to equity holders this risk incentive feature is unchanged by deposits being insured and hence excessive risk taking by depository institutions is not solely attributable to the flat rate insurance premium consequently the incentive problem cannot be resolved through a risk based insurance premium contrary to the prevailing view we propose a solution that eliminates risk shifting through an optimal tax structure and specify a corresponding insurance premium that is revenue neutral from the social planner s regulator s standpoint the solution is derived in the context of a social objective function that trades off the benefits of liquidity services by banks and the unique informational role of bank loans with the costs of investment distortions engendered by risk shifting

appearance and reality in deposit insurance the case for reform abstract this paper argues that the staffs and explicit insurance reserves of u s deposit insurers have been overwhelmed by de facto financial disaster the full costs of financing federal deposit insurance have become enormous and increasingly inequitable in distribution to reduce voluntary risk taking authorities must reprice and redesign the system of de facto deposit insurance coverage six complementary reforms are discussed 1 accounting for institutional assets liabilities and net worth at market value 2 enhancing opportunities for deposit insurers to manage their risk exposure 3 recalibrating insurance coverages 4 imposing risk rated premiums 5 mixed private and governmental competition in deposit insurance and 6 constraining insurance agency and federal reserve authority to bail out insolvent institutions

collateral loan quality and bank risk abstract most commercial loans are made on a secured basis yet little is known about the relationship between collateral and credit risk several theoretical studies find that when borrowers have private information about risk the lowest risk borrowers tend to pledge collateral in contrast conventional wisdom holds that when risk is observable the highest risk borrowers tend to pledge collateral an additional issue is whether secured loans as opposed to secured borrowers tend to be safer or riskier than unsecured loans empirical evidence presented here strongly suggests that collateral is most often associated with riskier borrowers riskier loans and riskier banks

the s l debacle public policy lessons for bank and thrift regulation this book describes the period of failures of savings and loan associations and sets out a program of policies to prevent future debacles it explains the regulatory actions and inactions that created the incentives for large numbers of thrifts to make excessively risky and ill conceived and in some cases fraudulent and criminal investments it describes the failure of the accounting system to provide adequate information to regulators and in many cases even to the managers of the thrifts themselves concerning the health and riskiness of individual thrifts it also discusses how the regulatory system that had been conceived in an earlier and highly regulated era was overwhelmed in the deregulated environment of the early 1980s it shows how the reforms that were made in response to the growing crisis were too little and too late and finally it offers a set of policy reforms that could prevent future crises in the savings and loan industry this work should be of interest to political and financial economists

deposit insurance and the discount window pricing under asymmetric information the risk sensitive pricing of deposit insurance and the discount window is determined in an environment where banks have private information concerning their financial conditions the two facilities are managed jointly an incentive compatible policy is designed such that banks choice of terms at which they can obtain insurance and access to discount window credit will reveal their asset quality the function of the discount window is to be a risk neutral lender of last resort to banks in a market dominated by risk averse depositors the need to regulate banks is commonly linked to the risk independent pricing of deposit insurance in that it provides banks with an incentive to increase their risk taking activities 1 critics of the present system have long advocated risk sensitive deposit insurance premiums and a literature is emerging that examines the variety of such pricing schemes 2 this literature typically assumes that the public insuring agency has the same information as the bank concerning the quality of the bank s assets this is both implausible and potentially misleading the bank normally has superior information concerning its assets a pricing policy that ignores this informational asymmetry is likely to provide banks with similar risk taking incentives that is associated with the current riskinsensitive pricing arrangement kane 6 p 275 for example appreciates this aspect of the problem i t is necessary not only to reprice but also to redesign the existing system the fdic and fslic must develop incentive compatible my emphasis insurance contracts and price them fairly contractual incentives must be established that would allow a low risk institution to lower its premiums by communicating to the insurance agency what its own managers know about the institution s own exposure therefore as kane argues a redesigned insurance system is needed that would provide incentives to the banks to truthfully reveal the necessary information and thereby facilitate the efficient pricing of the risk shifted to the public insurer a variety of pricing policies that involve a bank s choice of capital or asset liability composition

considerations of cost trade offs in insurance solvency surveillance policy abstract we propose a process for identifying potentially insolvent insurers on a cost effective basis a loss cost function is developed such that the effectiveness of monitoring is maximized relative to a cost constraint the loss cost function is supported by a model that provides a rank ordering of financial institutions according to their probability of insolvency when tested against a full sample of property liability insurance companies the procedure provides information critical to maximizing the effectiveness of regulatory resources available for solvency surveillance and performs well as a predictor of insolvency likewise the rank ordering of insurers overcomes an estimation problem critical to establishing risk adjusted guaranty assessments

variable rate deposit insurance a re examination abstract this paper investigates the impact of variable rate deposit insurance on the financial and real sectors of the economy and its role as an absorber of bankruptcy risk within these sectors a variable rate system raises the cost of funds to the real sector and increases probability of bankruptcy of the borrowing firms when such bankruptcies occur society experiences a dead weight loss we argue that appropriate deposit insurance pricing must weigh the social costs connected with both financial firm failure and real sector bankruptcy

the effects of shifts in monetary policy and reserve accounting regimes on bank reserve management behavior in the federal funds market abstract this paper looks at the effects on fed fund rates and fed fund purchasing behavior of large banks resulting from i the 1982 regime switch from non borrowed to borrowed reserve targeting by the fed and ii the 1984 switch from lagged to almost contemporaneous reserve accounting cra whether we analyse changes in the interest rate or quantity dimensions the shift in monetary policy targets appeared to have had a more profound effect on the market for bank reserves than the shift in reserve accounting regime these results therefore tend to support the contention that a shift to cra by itself will have little effect on bank reserve management behavior unless combined with its logical counterpart a total reserves target

moral hazard and optimal commodity taxation abstract this paper demonstrates that in an economy with moral hazard and more than one commodity competitive equilibrium is not constrained efficient to correct the market failure differential commodity taxation is necessary a general optimal tax formula is derived and special cases of is discussed

rights equity and economic efficiency the adelman morris premise that economic development and equity are incompatible is not supported by the evidence of a strong relationship between equality of rights and the income distribution the premise that equity requires the denial of individual rights and the affirmation of state control is an oxymoron what has been overlooked in the literature on growth and equity is the effect of the rights structure on both economic efficiency and on the income distribution the evidence is that free societies have much larger shares of income going to the middle 60 percent of the distribution than is observed in societies where men are not free to choose in politically open societies compared to politically closed regimes the share of income to the middle three quintiles is q2 10 7 vs 8 0 q3 16 0 vs 11 5 and q4 22 9 vs 17 9 in the aggregate the shares to the middle quintiles are 49 6 vs 37 4 in nations that obey the rule of law compared to regimes in which the rights of the state relative to the individual are paramount the comparisons are q2 11 2 vs 7 4 q3 16 3 vs 10 6 q4 23 0 vs 17 3 summing the three quintiles yields a comparison of 50 5 vs 35 3 in countries that have private property market allocation of resources and minimum intervention by the state compared to command economies the shares of income to the middle quintiles are q2 10 8 vs 8 0 q3 16 0 vs 11 1 and q4 22 8 vs 17 7 aggregated the shares of the middle class in regimes with high levels of economic liberty are 49 6 vs 36 8 for regimes with restricted private economic rights

rule and policy spaces and economic progress lessons for third world countries despite greater rates of capital accumulation per capita growth rates among third world nations particularly africa are much lower than among the advanced capitalist nations in this paper i examine the critical roles of the rule space and policy on economic growth empirically nations with poor institutions and policies grow at about a fifth of the rate of nations with good institutions and policies

federal deposit insurance regulatory policy and optimal bank capital this paper seeks to explain the combination of explicit and implicit pricing for deposit insurance employed by the fdic essentially the fdic sells two products insurance and regulation to span the product space it must and does set two prices we argue that the need to establish regulatory disincentives to bank risk taking is the heart of the controversy over the adequacy of bank capital and that the ability to close risky banks before exhausting their charter value i e the value of their right to continue in business stands at the center of these disincentives and in front of the fdic s insurance reserves just as a book shouldn t be judged by its cover a government agency shouldn t be judged by the words behind its initials with the fdic federal deposit insurance corporation the agency s name describes only part of its formal operations the fdic is quasi governmental has a regional structure and sells deposit insurance however the initials fail to convey the fdic s critical place in the governmental regulatory structure as the sole federal overseer of the approximately 8900 state chartered commercial banks that have chosen not to belong the federal reserve system reflecting the federal reserve s membership problem the number of these banks is growing year by year besides selling deposit insurance at bargain explicit rates the fdic performs four regulatory functions 1 entry regulation it passes on new banks applications for deposit insurance and on branch and merger proposals as well thereby protecting the value of existing bank charters 2 examination two thirds of fdic employees are concerned with inspecting bank records and supervising managerial activity 3 regulation of deposit rates and conditions for withdrawal by tradition fdic policies on these matters conform entirely with regulations applicable to federal reserve member banks and 4 disposition of failed banks when an insured bank fails the fdic usually chooses not to liquidate it 2

economic freedom government policy and the trade off between equity and economic growth this study investigates the role that economicfreedom plays in economic growth and in the distribution in marketincome the role of government policy in advancingeconomic progress and in promoting income equality and the effectthat the rate of economic progress has on thedistribution of market income structural and reduced formmodels are estimated that reveal that economic freedompromotes both economic growth and equity and that there is apositive but relatively small trade off between growth andincome inequality

the institutional framework and economic development the compound growth rates of per capita output and farrell type efficiency measures for 115 market economies over the period 1960 80 were compared with measures of political civil and economic liberty it was found that the institutional framework has significant and large effects on the efficiency and growth rate of economies politically open societies which subscribe to the rule of law to private property and to the market allocation of resources grow at three times the rate and are two and one half times as efficient as societies in which these freedoms are abridged

institutional technology and economic growth an endogenous model of constitutional changes and economic growth links the temporal decline in private market returns when technology is constant with the returns to rule changes realized in a political market there is a steady state constitutional setting in which all rule changes have been incorporated that is analytically equivalent to the neoclassical steady state as in the neoclassical model private sector technological progress postpones the steady state to the extent the original constitutional setting promotes innovation the evolutionary process toward the steady state is delayed the model yields a theory of revolution based on forces leading to the adoption of inefficient changes in the constitutional setting

the valuation of fdic deposit insurance using option pricing estimates when congress set the premium rate for fdic deposit insurance in the banking act of 1935 which authorized a permanent federal insurance system neither experience nor theory could offer much guidance regarding an appropriate fee structure although rates have since been periodically revised the fdic has yet to attempt to set the insurance rate at a ifair level that is a level equal to administrative costs plus the ex ante value of the insurance such a premium is the rate that would be charged by competitive private insurers however7 the garn st germain act of 1982 directed the fdic to consider the feasibility of a risk based premium structure in response the fdic has suggested a trial system in which each insured bank will be placed in one of three risk classes based on credit and interest rate risk relative to capital and a premium rate will be assigned to each group those rates will be determined in part by the loss experience of the entire banking system fdic 1983 another approach to the determination of the appropriate insurance premium has been offered by merton 1977 who suggested using the analogous relationship between deposit guarantees and put options to value fdic insurance in this paper we follow merton s suggestion and calculate bank specific estimates of the proper premium for deposit insurance for the banks in our sample we find that fdic rates greatly exceed estimates of the fair value of the insurance derived from the blackscholes 1972 option pricing model

bank regulation and monetary policy the depository institutions deregulation and monetary control act 1980 and the garn st germain depository institutions act 1982 are the two most significant pieces of bank legislation since the 193os their significance stems from the fact that they have sought to roll back a number of the regulations and restrictions imposed on bank activity and competition in the 1933 80 period among the important provisions of these acts are a gradual elimination of regulation q ceilings on time and savings deposits by march 1986 the amelioration of state imposed usury ceilings on loans the nationwide provision of interest bearing transaction type accounts negotiable order of withdrawal now and super now accounts permission for thritts to expand into bank like products such as commercial and industrial loans consumer loans and credit cards and the development of new types of savings accounts such as mmdas l in addition to legislative deregulation we have also witnessed homemade deregulation as banks have sought to exploit often with great success loopholes in the bank holding

externalities in economies with imperfect information and incomplete markets this paper presents a simple general framework for analyzing externalities in economies with incomplete markets and imperfect infonnation by identifying the pecuniary effects of these externalities that net out the paper simplifies the problem of determining when tax interventions are pareto improving the approach indicates that such tax interventions almost always exist and that equilibria in situations of imperfect information are rarely constrained pareto optima it can also lead to simple tests based on readily observable indicators of the efficacy of particular tax policies in situations involving adverse selection signaling moral hazard incomplete contingent claims markets and queue rationing equilibria traditional discussions of externalities have emphasized the distinction between technological externalities in which the action of one individual or firm directly affects the utility or profit ofanother and pecuniary externalities in which one individual s or firm s actions affect another only through effects on prices while the presence of technological externalities imply in general that a competitive equilibrium may not be pareto efficient pecuniary externalities hy themselves are not a source of inefficiency the fact that prices change has of course important consequences there are both distributional and allocational effects but the distribution effects net out gains for example hy firms whose prices increase are precisely offset by losses e g to individuals who must pay higher prices and there are no welfare losses from the allocation effects as long as the price changes involved are small if firms are maximizing profits and individuals are maximizing utility both facing prices that correctly refiect opportunity costs then standard envelope theorem arguments imply that changes in profits or utility induced by changes in allocations resulting from any small change in prices are negligible

establishment size and local employment growth in a sample of more than 2000 u s counties smaller average establishment size is generally associated with faster subsequent growth rates of sectoral employment both within and across sectors the estimated effects are large in magnitude and thus economically important and are consistent with several theories previously developed these findings contribute toward a more precise understanding of the role of small businesses in economic growth and labor markets

market discipline and bank subordinated debt note a lengthy literature in banking has addressed the question of whether the market prices of liabilities respond to individual bank risk taking activity that is whether any market disciplines exists however despite the obvious importance of this question the current record has led to no consensus on the issue results have been contradictory in this journal alone hannan and hanweck 1988 conclude that the market does extract at least some price for risk taking while avery belton and goldberg 1988 find no such evidence in this study we argue that this line of inquiry has a serious f law in that it fails to use theoretical models of bank instrument valuation to determine the appropriate testing of market discipline therefore the empirical models have lacked the necessary exactness to isolate the appropriate null hypotheses to redress this shortcoming and advance the methodology of this area of the literature we use a pricing model which comes to the banking area from the options pricing literature to look at the yield spread on bank liabilities using this model it is clear that the value of large uninsured bank liabilities cannot be described as a linear monotonic function of risk moreover current bank regulation affects the assumed role risk measures play in the pricing of such debt instruments both of these complications mean that simple regressions are not likely to adequately address the relationship between the value of debt and underlying risk in the final section we empirically investigate the presence of market discipline using contingent claims pricing we find that accounting measures of bank risk still have little predictive value in explaining yield spreads and therefore offer little evidence of meaningful market discipline

optimal bank reorganization policies and the pricing of federal deposit insurance optimal dynamic regulatory policies for closing ailing banks and for deposit insurance premia are derived as functions of the rate of flow of bank deposits and interest rate on deposits the economy s risk free interest rate and the regulators bank audit administration costs under competitive conditions the threshold assets to deposits ratio below which a bank should be optimally closed is shown to be greater than or equal to one optimal deposit insurance premia and probabilities of bank closure are shown to be nondecreasing in the bank s risk on investment and nonincreasing in the bank s current assets to deposits ratio should regulatory agencies close reorganize an ailing federally insured financial institution if so when the recent record rate of failures of savings and loans associations s ls has renewed the urgency of this question the regulatory agencies are empowered but not required to reorganize financial institutions that are statutorily insolvent i e have zero or negative regulatory net worth recently regulators have in many instances permitted insolvent financial institutions to remain in operation 2 also while debating on the increase of the proposed funding of the federal deposit insurers the u s congress argued whether it would be desirable and if so when to close more s ls thus when regulators should close a troubled financial institution has become a major question of bank regulatory policy while the existing academic literature provides powerful insights into the structure and pricing of the insurers liability this literature offers very little guidance regarding the timing of bank reorganizations 3 indeed to the best of our knowledge the value of the federal

a reexamination of the over or under pricing of deposit insurance this study shows how fair deposit insurance premia can be calculated using data on bank stock prices interest rate movements and income and balance sheet accounts fair insurance premia are estimat ed under the alternative assumptions that the fdic provides either a limited term variable rate or unlimited term insurance cont ract to banks the paper s results suggest that for nearly all of the large commerical banks in the sample the actual insurance premium c harged by the fdic falls between the bounds of fair limited term and unlimited term insurance premia copyright 1987 by ohio state university press

a theory of competition among pressure groups for political influence this paper presents a theory of competition among pressure groups for political influence political equilibrium depends on the efficiency of each group in producing pressure the effect of additional pressure on their influence the number of persons in different groups and the deadweight cost of taxes and subsidies an increase in deadweight costs discourages pressure by subsidized groups and encourages pressure by taxpayers this analysis unifies the view that governments correct market failures with the view that they favor the politically powerful both are produced by the competition for political favors