Government Deposit Insurance and the Diamond-Dybvig Model

The apparent banking market failure modeled by Diamond and Dybvig [1983] rests on their inconsistently applying their sequential servicing constraint to private banks but not to their government deposit insurance agency. Without this inconsistency, banks can provide optimal risk-sharing without tax-based deposit insurance, even when the number of type 1 agents is stochastic, by employing a contingent bonus contract. The threat of disintermediation noted by Jacklin [1987] in the nonstochastic case is still present but can be blocked by contractual trading restrictions. This article complements Wallace [1988], who considers an alternative resolution of this inconsistency.