Estimating risk in banks: What can academic research tell us?

It is generally agreed that like other types of insurance, deposit insurance premiums should be proportional to risk. A failure to do so can introduce economic inefficiencies in the sense that low risk-takers would, in effect, be subsidizing high risk-takers. Deposit insurance that is not responsive to risk-taking also introduces moral hazard in the sense that managers might take on excessive risk knowing that deposit insurance provides protection, but does not discipline the manager through higher insurance premiums. The decision to operate deposit insurance with premiums that are responsive to risk carries with it a need to determine risk levels across insured institutions. This article summarizes the academic research on measures of risk in banking with a focus on the areas that would be of primary interest to bank deposit insurers, regulators and supervisors.