Optimal Bank Portfolio Choice Under Fixed-Rate Deposit Insurance

This paper analyzes the optimal investment decisions of insured banks under fixed-rate deposit insurance. In the presence of charter value, trade-offs exist between preserving the charter and exploiting deposit insurance. Allowing banks to dynamically revise their asset portfolios has a significant impact on both the investment decisions and the fair cost of deposit insurance. The optimal bank portfolio problem can be solved analytically for constant charter value. The corresponding deposit insurance is shown to be a put option that matures sooner than the audit date. An efficient numerical procedure is also developed to handle more general situations.