Imperfect Renegotiations in Interbank Financial Networks

Management Science, Forthcoming

38 Pages Posted: 25 Mar 2008 Last revised: 26 May 2017

See all articles by Alexander David

Alexander David

Haskayne School of Business, University of Calgary; University of Calgary - Haskayne School of Business

Alfred Lehar

University of Calgary - Haskayne School of Business

Date Written: March 14, 2017

Abstract

Interbank financial networks enable banks to share the risks in their assets, but potentially also increase systemic spillovers of insolvency from one bank to others in the network. We model a renegotiation game to explicitly examine the forgiveness of commitments of insolvent banks by solvent banks to limit the systemic transmission of financial distress. The assets of the insolvent bank can be appropriated by the forgiving bank in the two-bank network, but not the three-bank network, where they may be appropriated by the third bank, leading to a renegotiation breakdown. We also show how banks can ex-ante optimally construct networks from interbank loans and derivatives to minimize the costs of such inefficient financial distress.

Keywords: Systemic risk; interbank financial networks; renegotiation breakdowns; derivatives

JEL Classification: G21, C1, C78, C81, E44

Suggested Citation

David, Alexander and Lehar, Alfred, Imperfect Renegotiations in Interbank Financial Networks (March 14, 2017). Management Science, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1108870 or http://dx.doi.org/10.2139/ssrn.1108870

Alexander David (Contact Author)

Haskayne School of Business, University of Calgary ( email )

2500 University Drive NW
Calgary, Alberta T2N1N4
Canada
403-220-6987 (Phone)

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

Alfred Lehar

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada
403-220-4567 (Phone)

HOME PAGE: http://homepages.ucalgary.ca/~alehar/

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