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I: Connectedness, Contagion, and Correlation: Definitions and a Review of the Economic Literature

Published onApr 08, 2020
I: Connectedness, Contagion, and Correlation: Definitions and a Review of the Economic Literature

This part gives an overview of the concepts of connectedness, contagion, and correlation, the three Cs of systemic risk. For a detailed literature review on these concepts, see the appendix. Connectedness describes the concern that the failure of one bank will cause the failure of others through balance sheet links. In asset connectedness, the failure of one bank will destabilize other banks that own its debt or equity, or are exposed through derivatives contracts. In liability connectedness, the failure of a bank that is an important source of short-term credit will destabilize banks that depend on it for funding. Correlation describes the failure of multiple institutions due to a collapse in asset prices. Contagion is the indiscriminate spread of run-like behavior throughout the financial system, including to healthy institutions. There may be important relationships and some degree of overlap between connectedness and contagion. For example, liability connectedness may intensify contagion. Correlated declines in real-estate prices were the spark that ignited the contagious panic observed in the 2008–2009 financial crisis. Nonetheless, the three Cs are distinct concepts. A review of the literature leads to a number of points about the current state of academic research on systemic risk. First, most of the connectedness literature is focused on liabilities rather than assets. Second, the existence of asset connectedness does not necessarily imply an increase in risk, since collateral, hedging, and diversification all serve to reduce risk. Third, the connectedness literature that discusses the concept of “indirect” connectedness is really discussing correlation and not connectedness. Finally, none of the academic literature materially addresses the principal problem of contagion.

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