Internal model-based capital standard and the cost of deposit insurance

Abstract

The new Basel Accord (known as Basel II) attempts to introduce more risk-sensitive capital requirements. We propose a multiperiod deposit insurance pricing model that incorporates specific regulatory capital requirements and the possibility of capital forbearance and moral hazard. We estimate the cost of deposit insurance under alternative regulation regimes based on the building block approach of the 1988 Basel Accord (known as Basel I) and internal model-based (IMB) capital regulation. In contrast to the building block of Basel I, Basel II's IMB capital regulation links more closely the capital requirement to a bank's actual risk. We develop a multiperiod pricing model while incorporating the effects of capital forbearance and moral hazard. The fairly-priced premium rates are computed by assuming that a bank's asset value follows a GARCH process. In contrast to previous studies based on the building block capital standard, we find that forbearance and the potential moral hazard behavior will not increase the cost of deposit insurance in the scheme of Basel II's IMB capital regulation.

Citation

Lee, J.-P. (2008), "Internal model-based capital standard and the cost of deposit insurance", Chen, A.H. (Ed.) Research in Finance (Research in Finance, Vol. 24), Emerald Group Publishing Limited, Leeds, pp. 57-73. https://doi.org/10.1016/S0196-3821(07)00203-1