Portfolio Compression in Financial Networks: Incentives and Systemic Risk

We study portfolio compression, a procedure that removes cycles of liabilities in a financial network. We analyze 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, portfolio compression may be socially and individually detrimental and banks' incentives may be misaligned with social welfare. We then present sufficient conditions under which banks involved in the compression have an incentive to agree to it or under which the compression is even a Pareto improvement for all banks. Our results contribute to a better understanding of the implications of recent regulatory policy.