The Valuation of FDIC Deposit Insurance Using Option-Pricing Estimates

Abstract

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.