Risky Collateral and Deposit Insurance

This paper provides a new rationalization for deposit insurance and systemic disintermediations. I consider an environment in which borrowers face no penalty for failing to repay obligations except the loss of their collateral. I assume that this collateral has aggregate risk. For a subset of the exogenous parameters, I demonstrate that an optimal arrangement features deposit insurance. For a strictly smaller set of parameters, it is optimal in some states of the world to have systemic disintermediation and concomitant falls in real output. ∗Earlier versions of this paper circulated under the title, “Efficient Institutions of Intermediation.” A version of the paper was presented in seminars at the Federal Reserve Bank of Minneapolis, the Texas Monetary Conference, Stanford University, the 1999 SED conference, the Northwestern University Macroeconomics Workshop, the University of Wisconsin, and the University of Washington; I thank the participants in these seminars for their comments. I also thank Harold Cole, Jeff Lacker, Chris Sleet and especially Barbara McCutcheon for their comments. Further comments are welcome; contact the author at [email protected]. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.