The Role of Correlation in Systemic Risk: Mechanisms, Effects, and Policy Implications

Abstract

One of the important determinants of systemic risk relies in the common exposure to exogenous shock sources. Contagion risks are, unfortunately, clearly known in the effects, but the mechanisms and determinants of systemic stability have not yet been sufficiently analyzed. The objective of this study is to examine in detail how the intensity of the common exposure to shocks, measured by the correlation with the exogenous variables, affects systemic risk. Results show that the role of correlation has different effects on the various banks, linked to the specific characteristics of the assets and liabilities of each one. These findings can be of significant support to crisis management, and regulatory and supervisory actions, aimed at minimizing the occurrence and impact of banking crises, for maintaining the banking and financial system stability. With reference to policy, our results suggest to keep the attention of regulation and supervision on the reduction of correlation to common risk sources. It can be obtained by rebalancing the risk weighting so to lower the capital coverage needs for the less correlated assets classes, as the SME loans, and to raise it for the more correlated ones, as the financial trading activity.