Moral Hazard in the Diamond-Dybvig Model of Banking
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.
Key words: banking; private record-keeping; moral hazard; mechanisms; bank runs
Suggested citation: Andolfatto, David, and Ed Nosal, 2006. "Moral Hazard in the Diamond-Dybvig Model of Banking," Federal Reserve Bank of Cleveland, Working Paper no. 06-23.