THE COST OF DEPOSIT INSURANCE - DERIVATION OF A RISK-ADJUSTED PREMIUM

The paper develops a model for determining a risk-adjusted premium to be charged by the FDIC. The proposed model is an alternative to models based on the option pricing formula and introduces coinsurance and deductible clauses for deposit insurance. The resulting risk-sensitive insurance premium is: (1) an increasing function of the interest rate paid on a bank's deposits, the bank's loan-loss rate, the bank's deposit-to-capital ratio, and the expenses incurred by the FDIC and the insured bank; and (2) a decreasing function of the interest rate earned on the bank's loans and the rate of return of the FDIC's investments. The models with coinsurance and deductibles reduce the FDIC's liabilities and result in smaller insurance premiums than the full insurance model. A risk-adjusted insurance premium would encourage bankers and depositors discipline reducing the moral hazard problem existing under the current flat insurance premium.