Portfolio Compression in Financial Networks: Incentives and Systemic Risk

We study portfolio compression, a post-trade mechanism that eliminates cycles in a financial network. We study the incentives for banks to engage in compression and its systemic effects in terms of all banks' equities. We show that, contrary to conventional wisdom, compression may be socially and individually detrimental and incentives may be misaligned with the social good. We show that these effects depends on the parameters of the financial system and the compression in a complex and non-monotonic way. We then present sufficient conditions under which compression is incentivized for participating banks or a Pareto improvement for all banks. More in detail, compression is universally beneficial when interbank payments are subject to high default costs, when recovery rates are high, or when the participating banks’ balance sheets are sufficiently homogeneous. Furthermore, we show that banks only have an incentive to reject a compression if there are feedback paths of links that are not compressed. Our results contribute to a better understanding of the implications of recent regulatory policy.