Systemic Risk as Renegotiation Breakdown: The Role of Structured Investment Products

We study the role of structured investment products (SIPs) in enabling banks to better hedge the risks in their asset streams but in generating greater systemic risk the risk of nancial dis-tress spreading through the nancial system due to the linkages created by these contracts. By swapping out portions of their asset streams, banks lose the incentive to maintain the quality of their assets and compensate for lower quality with greater hedging. Banks attempt to renegotiate their SIP contracts ex post in the event of insolvencies at one or more banks to lower liquidation costs in the system. Renegotiations helps restore incentives but are unable to improve the equilibrium to the social optimum because they may break down and lead to inefcient liquidations. Breakdowns are endogenous in our model and occur in periods when several solvent banks are able to credibly threaten to `run ' from their obligations to weaker banks. The systemic transmission is greatest in periods of renegotiation breakdown. Pure interbank loans are ineffective in helping banks manage systemic risk, while asset swaps optimally chosen help increase social welfare and bank prots, lower credit risk, but increase the systemic risk of the system