Financial intermediation naturally arises when borrowers' payoffs are correlated. I show this using a costly enforcement model in which lenders need ex post incentives to enforce payments from defaulted loans. When projects have correlated outcomes, learning the state of one project (via...

Financial intermediation naturally arises when knowing how loan payoffs are correlated is valuable for managing investments but lenders cannot easily observe that relationship. I show this result using a costly enforcement model in which lenders need ex-post incentives to enforce payments from...

This paper investigates how financial-sector leverage affects macroeconomic instability and welfare. In the model, banks borrow (use leverage) to allocate resources to productive projects and provide liquidity. When banks do not actively issue new equity, aggregate outcomes depend on the level...