We develop a model in which collateral serves to protect creditors from the claims of other creditors. We find that, paradoxically, borrowers rely most on collateral when pledgeability is high. This is when taking on new debt is easy, which dilutes existing creditors. Creditors thus require collateral for protection against possible dilution by collateralized debt. There is a collateral rat race. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment. There is a collateral overhang. Our results suggest that policies aimed at increasing the supply of collateral can backfire, triggering an inefficient collateral rat race. Likewise, upholding the absolute priority of secured debt can exacerbate the rat race.

We develop a theory of banking that explains why banks started out as commodities warehouses. We show that warehouses become banks because their superior storage technology allows them to enforce the repayment of loans most effectively. Further, interbank markets emerge endogenously to support this enforcement mechanism. Even though warehouses store deposits of real goods, they make loans by writing new fake warehouse receipts, rather than by taking deposits out of storage. Our theory helps to explain how modern banks create funding liquidity and why they combine warehousing (custody and deposit-taking), lending, and private money creation within the same institutions. It also casts light on a number of contemporary regulatory policies.

We develop a theory of secured debt, unsecured debt, and debt with anti‐dilution covenants. We assume that, as in practice, covenants convey the right to accelerate if violated, but the new secured debt retains its priority even if issued in violation of covenants. We find that such covenants are nonetheless useful: They provide state‐contingent financing flexibility, balancing over‐ and underinvestment incentives. The optimal debt structure is multilayered, combining secured and unsecured debt with and without covenants. Our results are consistent with observations about debt structure, covenant violations, and waivers. They speak to a policy debate about debt priority.

We explain why banks and nonbank intermediaries coexist in a model based only on differences in their funding costs. Banks enjoy a low cost of capital due to safety nets and money‐like liabilities. We show that this can actually be a disadvantage: it generates a soft‐budget‐constraint problem that makes it difficult for banks to credibly threaten to withhold additional funding to failed projects. Nonbanks emerge to solve this problem. Their high cost of capital is an advantage: it allows them to commit to terminate funding. Still, nonbanks never take over the entire market, but other coexist with banks in equilibrium.

We use a labor‐search model to explain why the worst employment slumps often follow expansions of household debt. We find that households protected by limited liability suffer from a household‐debt‐overhang problem that leads them to require high wages to work. Firms respond by posting high wages but few vacancies. This vacancy posting effect implies that high household debt leads to high unemployment. Even though households borrow from banks via bilaterally optimal contracts, the equilibrium level of household debt is inefficiently high due to a household‐debt externality . We analyze the role that a financial regulator can play in mitigating this externality.