Imperfect Renegotiation in Interbank Financial Networks

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. This paper was accepted by Itay Goldstein, finance.