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Moral hazard in the Diamond-Dybvig model of banking

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  • David Andolfatto
  • Ed Nosal

Abstract

We modify the Diamond-Dybvig model studied in Green and Lin to incorporate a self-interested banker who has a private record-keeping technology. A public record-keeping device does not exist. We find that there is a trade-off between sophisticated contracts that possess relatively good risk-sharing properties but allocate resources inefficiently for incentive reasons, and simple contracts that possess relatively poor risk-sharing properties but economize on the inefficient use of resources. While this trade-off depends on model parameters, we find that simple contracts prevail under a wide range of empirically plausible parameter values. Although moral hazard in banking may simplify the optimal structure of deposit liabilities, this simple structure does not enhance the prospect of bank runs.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0623.

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Date of creation: 2006
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Handle: RePEc:fip:fedcwp:0623

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Keywords: Contracts ; Financial crises ; Banks and banking;

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  1. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  2. Edward J. Green, 1995. "Implementing Efficient Allocations in a Model of Financial Intermediation," Meeting papers, EconWPA 9506001, EconWPA.
  3. David Andolfatto & Ed Nosal & Neil Wallace, 2006. "The role of independence in the Green-Lin Diamond-Dybvig model," Working Paper 0615, Federal Reserve Bank of Cleveland.
  4. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  5. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 111(1), pages 103-123, February.
  6. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, American Economic Association, vol. 81(3), pages 497-513, June.
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