In this chapter, we turn our attention to the liability side of the balance sheet of financial institutions, in particular to deposits of commercial banks. This is particularly appropriate in light of massive deposit runoffs in the credit 2006–2011 crisis, which we document later in this chapter and in Chapter 37 on liquidity risk. This focus on deposits is also critical to correct valuation of the Jarrow-Merton put option as the best comprehensive measure of integrated credit risk and interest rate risk in the commercial banking sector. Why? Because we need to value a put option that includes both assets and liabilities of the financial institution because some of the liabilities may be providing a hedge of the assets. One of the advantages of the reduced form credit modeling technology of Chapter 16 is that it can handle the complex liability structure that is typical of large financial institutions, whereas the Merton model of Chapter 18 assumes a single zero-coupon bond as a liability. In fact, it is the multiperiod cash flows of nonmaturity deposits that explained much of the drama of the credit crisis.
The bulk of bank deposits and insurance liabilities are made up of securities with explicit maturities, although they are often putable (back to the bank or insurance company) by the consumer who supplied the funds, whether they come in the form of a time deposit or life insurance policy. These liabilities can be analyzed with the techniques ...