Discount Window Lending and Deposit Insurance

A banking model is constructed where roles for government-provided deposit insurance and discount window lending arise when there are restrictions on branch banking. Banks arise endogenously as an efficient arrangement for sharing risk. Discount window lending permits better risk sharing by making bank assets more liquid, but is limited because of a moral hazard problem which arises from adverse selection in the loan market. Deposit insurance also creates the potential for better risk sharing, but accomplishes this through contingent transfers rather than enhancing liquidity. Banks tend to take on more risk with deposit insurance and to take less care in screening loans, but this is consistent with an increase in welfare for depositors and borrowers. The author thanks seminar participants at the University of Iowa and the University of Illinois for helpful comments and suggestions. Financial support from the National Science Foundation and the research assistance of Gabriele Camera are gratefully acknowledged.