Banking and deposit insurance as a risk-transfer mechanism
AbstractThis paper models an economy in which risk-averse savers and risk-neutral entrepreneurs make investment decisions. Aggregate investment in high-yielding risky projects is maximized when risk-neutral agents bear all nondiversifiable risks. A role of banks is to assume nondiversifiable risks by pledging their capital in addition to diversifying risks. Banks, however, do not completely eliminate risks when monitoring by depositors is not perfect. Government deposit insurance that uses tax revenue to pay off depositors effectively remaining risks to entrepreneurs. Deposit insurance improves welfare because imperfect monitoring by the government results in income transfer among risk-neutral agents rather than lower production.
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Bibliographic InfoPaper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 1994-025.
Date of creation: 1994
Date of revision:
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