Banking and Insurance

This paper studies the economic role of financial institutions in economies where agents' incomes are subject to privately observable, idiosyncratic random events. The information structure precludes conventional insurance arrangements. However, a financial institution -- perhaps best viewed as a savings bank -- can provide partial insurance by generating a time pattern of deposit returns that redistributes wealth from agents with high incomes to those with low incomes, resulting in a level of expected utility higher than that achievable in simple security markets. Insurance is incomplete because the bank faces a tradeoff between provision of insurance and maintenance of private incentives.