This paper undertakes a simple general equilibrium analysis of the consequences of deposit insurance programs, the way in which they are priced and the way in which they fund revenue shortfalls. We show that the central issue is how the government will make up any FDIC losses. Under one scheme for making up the losses, we show that FDIC policy is irrelevant: it does not matter what premium is charged, nor does it matter how big FDIC losses are. Under another scheme, all that matters is the magnitude of the losses. And there is no presumption that small losses are “good.” We also show that multiple equilibria can be observed and Pareto ranked. Some economies may be “trapped” in equilibria with inefficient financial systems. Our analysis provides counterexamples to the following propositions. (1) Actuarially fair pricing of deposit insurance is always desirable. (2) Implicit FDIC subsidization of banks through deposit insurance is always undesirable. (3) “Large” FDIC losses are necessarily symptomatic of a poorly designed deposit insurance system.

Many claims have been made about the potential benefits and the potential costs of adopting a system of universal banking in the United States. We evaluate these claims using a model where there is a moral hazard problem between banks and "borrowers," a moral hazard problem between banks and a deposit insurer, and a costly state verification problem. Under conditions we describe, allowing banks to take equity positions in firms strengthens their ability to extract surplus, and exacerbates problems of moral hazard. The incentives of universal banks to take equity positions will often be strongest when these problems are most severe.

Cover page issue number is "573D".

We consider an environment in which risk-neutral firms must obtain external finance. They have access to two kinds of linear, stochastic investment opportunities. For one, return realizations are costlessly observed by all agents. For the other, return realizations are costlessly observed only by the investing firm; however, they can be (privately) observed by outsiders who bear a fixed verification cost. Thus, the second investment opportunity is subject to a standard costly state verification (CSV) problem of the type considered by Townsend (1979), Gale and Hellwig (1985), or Williamson (1986, 1987).

We examine the optimal allocations of investment between the two kinds of projects, as well as the optimal contract used to finance it. We show that the optimal contractual outcome can be supported by having firms issue appropriate (and determinate) quantities of debt and equity securities to outside investors.

The optimal debt-equity ratio necessarily depends (in part) on the firm’s asset structure. Investments in projects subject to CSV problems are associated (in a sense to be made precise) with the use of debt—as might be expected from the existing CSV literature. Investments in projects with publicly observable returns are associated with the use of external equity.

We examine in detail the relationship between the optimal asset and liability structure of the firm. We also describe conditions under which an increase in the cost of state verification shifts the composition of investment towards projects with observable returns, and reduces the optimal debt-equity ratio. Interestingly, the optimal debt-equity ratio is also shown to depend on factors that are irrelevant to asset allocations.

Finally, a large part of the interest in CSV environments has been due to the fact that they may result in equilibrium credit rationing. Our analysis has strong implications for the possibility of equilibrium credit rationing in more general CSV models.

We produce a theoretical framework that helps explain the co-evolution of the real and financial sectors of an economy in the growth process, as described by Gurley and Shaw. According to them, self-financed capital investment first gives way to debt finance and later to the emergence of equity as an additional instrument for raising funds externally. As the economy develops further, the aggregate ratio of debt to equity will generally fall. We analyze that portion of their account concerning the evolution of equity markets. We show that in an important sense, debt equity are complementary sources for the financing of capital investments.

We consider a two country growth model with international capital markets. These markets fund capital investment in both countries, and operate subject to a costly state verification (CSV) problem. Investors in each country require some external finance, but also provide internal finance, which mitigates the CSV problem. When two identical (except for their initial capital stocks) economies are closed, they necessarily converge monotonically to the same steady state output level. Unrestricted international financial trade precludes otherwise identical economies from converging, and poor countries are necessarily net lenders to rich countries. Oscillation in real activity and international capital flows can occur.

We investigate ex-ante efficient contracts in an environment in which implementation is costless. In this environment, standard debt contracts will typically not be optimal. Optimal contracts may involve defaults, even in states in which the borrower is fully able to repay. We then examine the welfare costs of arbitrarily restricting the set of feasible contracts to standard debt contracts. When model parameters are calibrated to realistic values, the welfare loss from exogenously imposing this restriction is extremely small. Thus, if the implementation costs are actually nontrivial (as seems likely), standard debt contracts will be (very close to) optimal.