Skip to main content

Deposit insurance and regulation in a Diamond-Dybvig banking model with a risky technology

Summary

Three deposit insurance schemes are studied in a version of the Diamond-Dybvig banking model with a risky technology. The schemes include a full deposit guarantee and two alternatives which people have suggested as ways to limit the moral hazard problem of deposit insurance: deductible and coinsurance. Regulation to suppress the moral hazard problem under each scheme takes the form of solvency and incentive compatibility constraints. When the regulation is relaxed slightly, as it might be under regulatory error, the insurer's payout is lower under the alternatives than under the full guarantee. However, the coinsurance and deductible schemes are less effective at preventing bank runs than the full guarantee. Moreover, in some environments, even the full guarantee itself does not provide enough reassurance to rule out bank runs.

This is a preview of subscription content, access via your institution.

References

  1. Bhattacharya, S., Gale, D.: Preference shocks, liquidity, and central bank policy. In: Barnett, W. A., Singleton, K. J. (eds.) New approaches to monetary economics, pp. 69–88. Cambridge: Cambridge University Press (1987)

    Google Scholar 

  2. Boyd, J. H., Rolnick, A. J.: A case for reforming federal deposit insurance. Federal Reserve Bank of Minneapolis 1988 Annual Report. Minneapolis, Minnesota (1988)

  3. Diamond, D., Dybvig, P.: Bank runs, deposit insurance, and liquidity. J. Pol. Econ.91, 401–419 (1983)

    Google Scholar 

  4. Chari, V. V., Jagannathan, R.: Banking panics, information, and rational expectations equilibrium. J. Finance43, 749–761 (1988)

    Google Scholar 

  5. Hazlett, D.: Deposit Insurance in a Diamond-Dybvig model. Working Paper, Whitman College (1995)

  6. Jacklin, C.: Demand deposits, trading restrictions, and risk sharing. In: Prescott, E., Wallace, N. (eds.) Contractual Arrangements for Intertemporal Trade, pp. 26–47. Minneapolis: University of Minnesota Press (1987)

    Google Scholar 

  7. Jacklin, C.: Market rate versus fixed rate demand deposits. J. Mon. Econ.32, 237–258 (1993)

    Google Scholar 

  8. Kareken, J. H., Wallace, N.: Deposit insurance and bank regulation: a partial-equilibrium exposition. J. Bus.51, 413–438 (1978)

    Google Scholar 

  9. Lin, P.: Banking, incentive constraints, and demand deposit contracts with nonlinear returns. Working paper, Southern Methodist University Dallas, Texas (1995) Econ. Theory8, 27–39 (1996)

    Google Scholar 

  10. Postlewaite, A., Vives, X.: Bank runs as an equilibrium phenomenon. J. Pol. Econ.95, 485–491 (1987)

    Google Scholar 

  11. Villamil, A. P.: Demand deposit contracts, suspension of convertibility, and optimal financial intermediation. Econ. Theory1, 277–288 (1991)

    Google Scholar 

  12. Wallace, N.: Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously. Quarterly Review of the Federal Reserve Bank of Minneapolis, pp. 3–16. (Fall, 1988)

Download references

Author information

Authors and Affiliations

Authors

Additional information

I am indebted to Neil Wallace, John Kareken, Ed Green, Nobuhiro Kiyotaki, Andy McLennan, Mike Stutzer, Jan Werner and an anonymous referee for their helpful comments.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Hazlett, D. Deposit insurance and regulation in a Diamond-Dybvig banking model with a risky technology. Econ Theory 9, 453–470 (1997). https://doi.org/10.1007/BF01213849

Download citation

  • Received:

  • Revised:

  • Issue Date:

  • DOI: https://doi.org/10.1007/BF01213849

JEL classification number

  • 62