Background

There are hundreds of financial institutions connected through a network of liabilities owed to each other. The value of a certain institution depends on the amount of money it has and the amount owed to it by other institutions.  Eisenberg and Noe introduced us to this theory in their paper, Systemic Risk in Financial Systems, 2001.  This theory is a basic model for the interconnectivity between financial institutions, and it is the basis for our project.  They introduced cyclical interdependence, where banks are connected via a massive and complex system of liabilities. The integrity of the system is dependent on whether or not all of the banks can pay off their loans to each other.  They offer a way to model the case that one or some banks cannot pay off their loans, and how this would affect the system as a whole.

These networks are known to have systemic risk, which is the risk associated with being in the industry.  This means that when one bank can no longer pay what it owes, the rest of the network will be directly or indirectly affected.  We offer the concept of another network type where each connection first goes through a central clearing party (CCP).  This allows the system to be regulated and allows us a channel in which we can reduce the systemic risk of the system as a whole.  It is a centralized clearing party funded by the government, but is used to help prevent defaults of major banks in the economy.  This is where the society node is helpful.  The money collected from society can be used to create the initial capital for the CCP.  In other words, the government invests in a figurative safety net for the major banks.  Financial institutions aim to reduce the risk of their activities.  The risk they face is either derived from the decisions that they make, or from the risk of being involved in the system. A low risk network would not only increase potential growth in the industry, but also add stability to the economy.