Government deposit insurance and the Diamond-Dybvig model

The apparent banking market failure modeled by Diamond and Dybvig [1983] re sts on their inconsistently applying their "sequential servicing constraint " to private banks but not to their government deposit insurance agency. Wi thout this inconsistency, banks can provide optimal risk-sharing without ta x-based deposit insurance, even when the number of "type 1" agents is stoch astic, by employing a "contingent bonus contract." The threat of disinterme diation noted by Jacklin [1987] in the nonstochastic case is still present but can be blocked by contractual trading restrictions. This article comple ments Wallace [1988], who considers an alternative resolution of this incon sistency.