Abstract
Diamond and Dybvig provide a model of intermediation in which deposit insurance can avoid socially undesirable bank runs. We extend the Diamond–Dybvig model to evaluate the costs and benefits of deposit insurance in the presence of moral hazard by banks and monitoring by depositors. We find that complete deposit insurance alone will not support the first‐best outcome: depositors will not have adequate incentives for monitoring and banks will invest in excessively risky projects. However, an additional capital requirement for banks can restore the first‐best allocation.
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