Imes Discussion Paper Series Institute for Monetary and Economic Studies Bank of Japan

This paper utilizes option pricing theory to analyze bank stock prices, as one method of estimating fair variable deposit insurance premium rates in accordance with individual bank default risk, and conducts empirical analyses using Japanese data. The purpose of the analyses is to discuss the framework of public organs’ delegate monitoring of bank management. One of the functions of the deposit insurance system is such monitoring. The present system in the U.S. incorporates the subjective judgment of a bank supervisor combined with certain objective criteria for setting premium rates. There is a need to analyze the types of methodologies that might be viewed as options for adoption in Japan. To determine whether setting premium rates based on stock price information is a valid and stable approach, comparative analysis is conducted on the results of trial calculations utilizing this method versus other bank management indices (credit ratings, etc.), and case analyses are carried out on failed banks. The conclusion is that while this method does involve a certain valuation error, it is an effective means to identify banks with bad conditions. Moreover, the results confirm that by making adjustments for the changes in market expectations regarding the forbearance of the supervisory authorities, the accuracy of the estimates can be improved. Finally, this paper gives considerations to the impact on bank management that could be expected if this method were actually adopted.