Optimal Bank Portfolio Choice Under Fixed-Rate Deposit Insurance

Abstract

This paper analyzes the investment decisions of insured banks under fixed-rate deposit insurance. The model takes into account the charter value and allows banks to dynamically revise their asset portfolios. Trade-offs exist between preserving the charter and exploiting deposit insurance. The optimal bank portfolio problem is solved analytically for a constant charter value. In any audit period, banks maximize their risk exposure before some critical time and act cautiously thereafter. The corresponding deposit insurance is shown to be a put option that matures at this critical time rather than at the audit date.

Keywords: Contingent Credit Default Swap, Counterparty Credit Risk, Jump Diffusion, Annuity Measure

JEL Classification: G13