Lévy Processes and the Financial Crisis: Can We Design a More Effective Deposit Protection?

Abstract

Deposit Guarantee Schemes (DGSs) are institutions whose main aim is to provide a safety net for depositors. If a bank fails, depositors will recover their bank deposits up to a certain limit. During the recent financial crisis, DGSs were brought at the centre of the political and financial debate, especially due to the fact that the some DGSs resulted incapable to react to the crisis because of the lack of funds set aside. In this paper we propose to use Lévy processes to simulate the loss distribution of deposits insured by a DGS in case of banks’ failure. The simulated distribution can be used to design an effective DGS. By simulating banks’ default and the corresponding losses, our model allows defining a target level for the funds to be collected in order to promptly and effectively respond to financial turmoil and protect the citizens. The proposed approach is applied to a sample of Italian banks.