THE TERM-STRUCTURE OF INVESTMENT AND THE BANKS INSURANCE FUNCTION

The article re-examines the proposition, first formulated rigorously b y Bryant (A model of reserves, bank runs, and deposit insurance, Journ al of Banking and Finance 4, 335-344, 1980) and Diamond and Dybvig (Ba nk runs, deposit insurance, and liquidity, Journal of Political Econom y 91, 401-419, 1983), that in a production economy with stochastic liq uidity shocks to the household sector, banks serve to provide optimal intertemporal insurance to consumers. The paper argues that in order t o understand the moral hazard problems inherent in this insurance prob lem, it is too narrow to consider solely the role of banks as provider s of liquidity. The paper develops a model with several investment opp ortunities in which banks have the additional function of asset divers ification. This pooling of intermediation functions is shown to reduce the moral hazard problem, thereby enhancing the stability of deposito ry contracts and increasing the scope of the banks' insurance function . (C) 1997 Elsevier Science B.V.