Formulating a model that compares the effects of a default in the network of major financial institutions in the United States to the same network with a central clearing party.
Financial institutions are the backbone of the economy. At their most basic function, they make it possible for lenders and investors to fund projects that will translate into growth in the economy. Banks have critical roles in the personal organization and savings of the people of the United States. People trust that banks will not fail or default on their loans, so they lend their money to the bank in return for financial services in the form of interest or credit accounts. These allow the average consumer to keep track of spending and saving, and this plays a critical role in maintaining the health of the economy. Banks are connected in a network of cyclical interconnections, where each bank may directly or indirectly rely on another bank. These institutions not only loan money to fund projects, but they also have liabilities among each other. In addition, there is a different type of network where the connections between the banks all go through a central clearing party (CCP) first. The central clearing party is a regulator, which is expected to reduce systemic risk. We study what happens to the networks with and without a CCP when certain strains are put on the banks and from that determine if a CCP reduces the systemic risk in the network. We use the Eisenberg-Noe theory to create a payoff algorithm, which determines the effect of the defaulting bank. Only liquid assets of banks are considered. We add society and a CCP into the algorithm ultimately measuring the risk between a system with and without a CCP when connected to society. When we implement this model, we found that the CCP does not significantly reduce the systemic risk given how large of an investment you need to create it. Contrary to intuition and our original expectation, we conclude by not recommending the CCP.