This paper examines the optimal interest margin, the spread between the loan rate and the deposit rate of a bank, when the risk of corporate borrower default is explicitly capped. Corporate borrower default risk is characterized by a lending function that includes corporate borrower risk and equity default probability. The equity of the bank can be viewed as a realized capped call option on its assets. This approach we will use is to calculate loan-risk sensitive insurance premium. The results show that when the investment value of the corporate borrower is high, market-based estimates of deposit insurance premium which ignore the realized cap are under valued. This type of situation calls for an increase in the deposit insurance premium in lieu with the asset risk of the corporate borrower. An increase in the corporate borrower's asset risk makes the bank more prone to loan risk-taking at a reduced margin when asset risk itself is low, but makes the bank more prudent to loan risk-taking at an increased margin when asset risk itself is high. Our results demonstrate why realized capped lending considerations may have further applicability to value fair deposit insurance premium in providing more stability in banking system.
International Journal of Innovative Computing, Information and Control 10(1), pp.19-38