Interest Rate Risk and Capital Adequacy For Traditional Banks and Financial Intermediaries
NBER Working Paper No. 237
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.
Document Object Identifier (DOI): 10.3386/w0237
Published: McCulloch, J. Huston. "Interest Rate Risk and Capital Adequacy for Traditional Banks and Financial Intermediaries," Risk and Capital Adequacy in Commercial Banks, ed. Sherman J. Maisel, 1981, Chicago: UCP.
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