We study a dynamic model of financial intermediation in which interbank lending is subject to moral hazard, where intermediaries can divert funds towards inefficient projects. We show that despite the presence of moral hazard, secured lending contracts can discipline the investment choices of all market participants — even those with whom they are not directly contracting — thus partially overcoming market frictions. Our results provide a characterization of the relationship between the intermediation capacity of the system on the one hand, and the extent of moral hazard, the distribution of collateral and the network of interbank relationships on the other. We use this characterization to show that due to the recursive nature of the moral hazard problem, small changes in fundamentals may result in significant drops in the financial system’s intermediation capacity, leading to a complete credit freeze.
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