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Interest Rate Risk and Capital Adequacy For Traditional Banks and Financial Intermediaries

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  • J. Huston McCulloch

Abstract

Traditionally, banks and financial intermediaries borrow short and lend long. This causes a risk of negative net worth (and failure, under simplifying assumptions), because the present discounted value of the assets is more volatile than that of the liabilities. This paper utilizes a new option pricing model for speculative assets whose log price relative is a symmetric stable Paretian random variable. This model is used to empirically evaluate the probability of failure and fair value of deposit insurance as a function of capital-asset ratio for a bank with demand liabilities and longer term, default-risk-free, perfectly marketable assets. The maturities used for the assets range from three months to 30 years (in order to incorporate thrift institutions). Implications for reserve requirement policy and for liability management are discussed.

Suggested Citation

  • J. Huston McCulloch, 1978. "Interest Rate Risk and Capital Adequacy For Traditional Banks and Financial Intermediaries," NBER Working Papers 0237, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0237
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    References listed on IDEAS

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    1. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
    2. J. Huston McCulloch, 1978. "The Pricing of Short-Lived Options When Price Uncertainty Is Log-Symmetric Stable," NBER Working Papers 0264, National Bureau of Economic Research, Inc.
    3. William F. Sharpe, 1977. "Bank Capital Adequacy, Deposit Insurance and Security Values, Part I," NBER Working Papers 0209, National Bureau of Economic Research, Inc.
    4. W. F. Sharpe, 1981. "Bank Capital Adequacy, Deposit Insurance, and Security Values," NBER Chapters, in: Risk and Capital Adequacy in Commercial Banks, pages 187-202, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Ivilina Popova & Peter H. Ritchken & James B. Thompson, 1995. "The changing role of banks and the changing value of deposit guarantees," Working Papers (Old Series) 9502, Federal Reserve Bank of Cleveland.
    2. Asli Demirgüč-Kunt, 1991. "Principal-agent problems in commercial-bank failure decisions," Working Papers (Old Series) 9106, Federal Reserve Bank of Cleveland.
    3. J. Huston McCulloch, 1978. "The Pricing of Short-Lived Options When Price Uncertainty Is Log-Symmetric Stable," NBER Working Papers 0264, National Bureau of Economic Research, Inc.
    4. Anlong Li & Peter H. Ritchken & L. Sankarasubramanian & James B. Thomson, 1993. "Regulatory taxes, investment, and financing decision for insured banks," Working Papers (Old Series) 9303, Federal Reserve Bank of Cleveland.
    5. Philip Kostov & Seamus McErlean, 2004. "Estimating the probability of large negative stock market," Finance 0409011, University Library of Munich, Germany.

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