Moral Hazard in the Diamond-Dybvig Model of Banking

31 Pages Posted: 19 Oct 2007

See all articles by David Andolfatto

David Andolfatto

Simon Fraser University (SFU) - Department of Economics; Federal Reserve Bank of St. Louis

Ed Nosal

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Date Written: December 2006

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.

Keywords: banking, private record-keeping, moral hazard, mechanisms, bank runs

Suggested Citation

Andolfatto, David and Nosal, Ed, Moral Hazard in the Diamond-Dybvig Model of Banking (December 2006). FRB of Cleveland Working Paper No. 06-23. Available at SSRN: https://ssrn.com/abstract=1022061 or http://dx.doi.org/10.2139/ssrn.1022061

David Andolfatto

Simon Fraser University (SFU) - Department of Economics ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada
604 291-5825 (Phone)
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Federal Reserve Bank of St. Louis ( email )

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Saint Louis, MO 63011
United States

Ed Nosal (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

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