ABSTRACT 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 defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large correlated portfolio provides ex post incentives for enforcement. Thus, intermediation dominates direct lending, and intermediaries are financed with risk‐free deposits, earn positive profits, and hold systemic default risk.

We introduce digital currency into a macro model with a banking sector in which financial frictions generate endogenous systemic risk and instability. In the model, digital currency is fully integrated into the financial system . Stablecoin issuance significantly increases the probability of a banking-sector crisis because it depresses bank deposit spreads, particularly during crises, which limits banks’ ability to recapitalize following losses. While banking-sector stability suffers, household welfare can still improve significantly. Financial frictions nevertheless limit the potential benefits of digital currencies. The optimal level of digital currency could be below what would be issued in a competitive environment. In contrast to stablecoins, which are backed by debt, tokenized deposits backed by traditional bank assets improve welfare without harming financial stability . The scope for welfare gains from stablecoins or tokenized deposits depends on how households value the liquidity services of digital currency relative to traditional deposits and on the cost of issuing stablecoins.

Lack of coordination for prudential regulation hurts developing economies but benefits advanced economies. We consider a two-country macro model in which countries have limited ability to issue state-contingent contracts in international markets, and equilibrium is constrained inefficient. Both countries have incentives to stabilize their economy by using prudential limits, but the emerging economy depends on the advanced economy to bear global risk. Intermediating global risk requires bearing systemic risk, which financially developed economies are unwilling to bear, preferring financial stability over credit flows. Advanced economies prefer tighter prudential limits than would occur with coordination, to the harm of emerging economies.

We study the effect of collateralized lending and securitization on international capital flows and welfare in a two-country general equilibrium model with idiosyncratic investment risk. The low-margin country (Home) endogenously supplies more safe assets and enables more risk sharing. Upon financial integration, capital flows from Foreign (high-margin country) to Home, leading to lower interest rates and a larger global supply of safe assets. Unlike in standard models with partial equity issuance, in our model, Home can lose from financial integration due to the endogenous reduction in risk sharing and aggregate shocks can generate large gross capital flows.

In March 2020, safe asset markets experienced surprising and unprecedented price crashes. We explain how strategic investor behavior can create such market fragility in a model with investors valuing safety, investors valuing liquidity, and constrained dealers. While safety investors and liquidity investors can form a symbiotic relationship with offsetting trades during times of stress, strategic interactions among liquidity investors harbor the potential for self-fulfilling fragility. When the market is fragile, standard flight-to-safety can have a destabilizing effect and trigger a “dash-for-cash” by liquidity investors. Well-designed policy interventions can reduce market fragility ex ante and restore orderly functioning ex post.