Title: Portfolio Compression: Incentives and Systemic Risk
Abstract: I present my ongoing work on the theory of portfolio compression, i.e., the elimination of cycles in financial networks. I will illustrate that compression can affect all banks positively, negatively, or that it can re-allocate capital among banks. Perhaps counterintuitively, the effect is non-monotonic in parameters such as default costs and banks' external assets. The fact that affected banks need to agree for compression to take place implies a potential incentive problem. I will discuss two incentive models. First, if compression is performed ex-post to a shock, banks are obliged to serve their creditors and incentives are aligned. Second, if compression is performed ex-ante to a shock, banks only serve their own interests and incentives may be misaligned. I will present sufficient conditions under which this cannot occur and draw connections to systemic properties such as banks' leverage. In practice, and notwithstanding my results, banks do not seem to approach compression as a strategic problem. I will argue that this can be explained by two aspects that affect banks' decision making: local information and uncertainty about the future.
