Banking as the Provision of Liquidity
This article represents a model economy in which demand deposits represent the optimal financial intermediation. Because these demand deposits are backed in part by an illiquid asset, the in termediary ("bank") is subject to panics in which each agent ration ally decides to withdraw his deposits, making all worse off. Banks ca n prevent panics only through a distortion of the optimal contract. T he government can prevent panics without this distortion by guarantee ing the return from deposits. The moral hazard introduced by this dep osit insurance induces the government to regulate the intermediary's portfolio and returns. Copyright 1988 by the University of Chicago.
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