Portfolio Compression in Financial Networks: Incentives and Systemic Risk

Abstract

We study portfolio compression, a procedure that removes cycles of liabilities in a financial network. We analyze the effect of compression on social welfare and the banks’ incentives to accept a compression proposal. Regarding social welfare, we show that, contrary to conventional wisdom, compression may be detrimental and banks’ incentives may be misaligned with social welfare. We then derive sufficient conditions that guarantee that compression leads to a Pareto improvement for all banks. Regarding incentives, it is known that compression may be detrimental for an involved bank. We analyze which network structures give rise to this effect and derive sufficient conditions such that the involved banks are never worse off when accepting a compression. Our results contribute to a better understanding of the implications of recent regulatory policy.

Keywords: Portfolio Compression, Financial Networks, Systemic Risk

JEL Classification: D85, G01, G28