Portfolio compression: Positive and negative effects on systemic risk

We show how conservative portfolio compression, ie, netting cycles in a financial network, can increase systemic risk even though the exposures of all banks to each other decrease. We provide a simple example where for a certain network structure and shocks to banks, portfolio compression is socially detrimental, but individually preferred by all banks that participate in the compression. We then show via simulations that whether or not portfolio compression is socially desirable depends on the intensity of a shock: compression can make a financial system more resilient to small shocks, but more vulnerable to large shocks.