The effect of relaxation of interstate banking restrictions on the probability of bank failures and the expected value of FDIC liabilities

The relaxation of interstate banking restrictions would allow small and medium-sized banks the opportunity to alter the composition of their loan portfolios. The issue addressed in this research is what affect this would have on the banks' riskiness. While the variance of asset returns is commonly used to measure risk from an investor's perspective, it is not the best measure of social risk. Two alternative measures of social risk, the probability of bank failure and the expected value of payout by the Federal Deposit Insurance Corporation (FDIC) are investigated. It is demonstrated that these risk measures are not always compatible with the variance as an indicator of risk changes;The project develops a 2-bank, 2-asset probabilistic framework to analyze the risk changes that result from geographic deregulation. Assuming that loan losses between regions are distributed as a truncated bivariate normal distribution, the necessary integrals to derive the desired probabilities and expected payouts are specified. Since no apparent closed-form solutions exist for the derivatives of these integrals, a simulation exercise is conducted to determine the changes in social risk that would result from deregulation. Using various assumptions about bank capitalization rates, the mean and variance of loan losses and the correlation of losses between regions, the sensitivity of the results are examined;The results suggest that geographic deregulation would provide the opportunity for banks to reduce their probability of failure and the expected payout by the FDIC to a representative bank. However, whether banks actually reduce their riskiness will depend on their portfolio reoptimization. From a systemic viewpoint, it is shown that the probability of a bank failing would likely decline, but the probability of multiple bank failures would increase. Finally, the total expected payout by the FDIC would potentially decline.