Correlation and Contagion as Sources of Systemic Risk

Abstract

We study systemic risk in a network model of the interbank market where the asset returns of the banks in the network are correlated. In this way we can study the interaction of two important channels for systemic risk (correlation of asset returns and contagion due direct financial linkages). We carry out a simulation study that determines the probability of a systemic crisis in the banking network as a function of both the asset correlation, and the connectivity and structure of the financial network. An important observation is the fact that the relation between asset correlation and the probability of a systemic crisis is hump-shaped; in particular, lowering the correlation between the asset returns of different banks does not always imply a lower probability of a systemic crisis. Moreover, in contrast to other studies we find that diversification at the level of individual banks may be beneficial for financial stability even if it does lead to a higher asset return correlation.