The Changing Role of Banks and the Changing Value of Deposit Guarantees

This article develops a model for pricing deposit guarantees. The model treats the bank’s investments as a portfolio of default-free bonds and risky loans. The risk of the loans is determined by individual firms’ financing and investment decisions. Pushing back risk to the level of the borrowing firms allows us to link deposit guarantees to specific characteristics of these loans, such as their durations, and to correlations between business risk and interest rates. Since the nature of bank loans has been changing over time, our model should predict the accompanying change in value of the government guarantees.