PRICING DEPOSIT INSURANCE WHEN THE INSURER MEASURES BANK RISK WITH ERROR

If the deposit insurance agency ('FDIC') can observe bank risks without error, it can attain actuarial soundness equally well with either risk-related premium assessments or risk-related capital standards. However, many bank assets are difficult and expensive to evaluate, so their true value and risk cannot be ascertained without error. These risk measurement errors cause the FDIC to misprice its deposit insurance, which can be analyzed as a put option written on assets with uncertain volatility and current value. This paper evaluates the optimal means of pricing deposit insurance in such an environment. Because FDIC's insurance pricing errors increase with bank leverage, the impact of these errors on private-sector allocations can be minimized with a combination of risk-related capital standards and risk-related premia. © 1991.