On Flexibility, Capital Structure, and Investment Decisions for the Insured Bank

Most models of deposit insurance assume that the volatility of a bank’s assets is exogenously provided. Although this framework allows the impact of volatility on bankruptcy costs and deposit insurance subsidies to be explored, it is static and does not incorporate the fact that equity holders can respond to market events by adjusting previous investment and leverage decisions. This paper presents a dynamic model of a bank that allows for such behavior. The flexibility of being able to respond dynamically to market information has value to equityholders. The impact and value of this flexibility option are explored under a regime in which flat-rate deposit insurance is provided.