Optimal bank loan rate and default risk in equity return under capital regulation and deposit insurance

This is a study that uses Merton's (1974) option pricing model to value default measures for a bank and assess the effects of regulatory parameters on the bank's equity return and default risk. We find that an increase in the capital-to-deposits ratio or in the deposit insurance premium results in a reduced the bank's interest margin (and thus the bank's equity return) under the negative elasticity effect. An increase in either regulatory parameter has a positive effect on the default risk in the bank's equity return. Our findings provide alternative explanations for the theoretical argument concerning the bank interest margin and default risk in equity return under regulations.