Interbank Hedging and Systemic Risk: The Role of Renegotiation Breakdowns

Banks use over-the-counter derivative (OTCD) contracts for sharing the risks of their asset streams. OTCDs are composed of an optimal combination of interbank loans, asset swaps and credit default swaps (CDS). The settlement of ex-post realized claims are renegotiated by participating banks after defaults by one or more banks to minimize the systemic impact of the default. The bailout by a solvent bank of an insolvent one creates a positive externality for all other solvent banks in the system with claims due from the insolvent bank. The lack of coordination among the solvent banks leads to an inefficient liquidation policy (system-wide runs) even though we allow mergers among them to potentially internalize the positive externality. Interbanks loans and CDS contracts have relatively lower incentive costs than swaps, but the former has the largest distress costs without renegotiations. With renegotiations, the payoffs of interbank loans and CDS are similar in strong bankruptcy regimes, while the latter dominate in weak regimes. Asset swaps provide the best hedging and are optimal for banks without incentive problems. Hedging with optimal OTCD contracts creates a tradeoff between the amount of credit risk and systemic risk (liquidation spillover) in the banking system. JEL Classification: G21, C1, C78, C81, E44 Both authors are at the Haskayne School of Business, University of Calgary. We are grateful to Philip Bond, Michael Brennan, Phil Dybvig, Ron Giammarino, Alan Kraus, Joe Ostroy, Roberto Rigobon, Chris Rogers, and to seminar participants at University of Alberta, University of British Columbia, McGill Risk Management Conference, Northern Finance Association Meetings in Kananaskis, and University of Waterloo for helpful comments. Address: 2500 University Drive NW, Calgary, Alberta T2N 1N4, Canada. Phone (David): (403) 220-6987. Phone (Lehar) (403) 220-4567. Fax (both): (403) 210-3327. E. Mail (David): [email protected]. E. Mail (Lehar): [email protected].