This paper studies the provision of deposit insurance along with liquidation decisions without commitment in an economy with heterogenous households. The analysis separates control of the balance sheet of a failed bank from the provision of deposit insurance. We study the factors that determine orderly liquidation and the effects of this policy on the prospect of bank runs. We also study the provision of deposit insurance and its financing. Redistribution plays a key role in the deposit insurance decision. When households are identical, deposit insurance will be provided ex post to reap insurance gains. But the ex post provision of deposit insurance redistributes consumption when households differ in their claims on the banking system as well as in their tax obligations to finance the deposit insurance. Deposit insurance will not be provided ex post if it requires a (socially) undesirable redistribution of consumption which outweighs insurance gains. Heterogeneity across households also impacts the optimal liquidation decision.

Link to the paper: https://www.dropbox.com/s/ecz4gsfphukiik2/real_DI_Mar2013.pdf

(joint work Hubert Kempf (PSE)