Imperfect Renegotiations in Interbank Financial Networks
Management Science, Forthcoming
38 Pages Posted: 25 Mar 2008 Last revised: 26 May 2017
Date Written: March 14, 2017
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: Suggested Citation