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Connectedness and ContagionProtecting the Financial System from Panics$
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Hal S. Scott

Print publication date: 2016

Print ISBN-13: 9780262034371

Published to MIT Press Scholarship Online: January 2017

DOI: 10.7551/mitpress/9780262034371.001.0001

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The Concept of Correlation

The Concept of Correlation

(p.15) 3 The Concept of Correlation
Connectedness and Contagion

Hal S. Scott

The MIT Press

This chapter discusses the third of the three components of systemic risk: correlation. Correlation describes the failure of multiple institutions resulting from the collapse of asset prices due to an exogenous event (e.g. the fall of housing prices in the period prior to the 2008–2009 financial crisis). Correlation can also refer to the herding instinct of asset managers that can result in market crashes and instability, or in irrational asset bubbles. Recently, the risk of the asset management industry's herding behavior has come to the forefront of discussions about correlation risk, as it may result in market crashes and instability, particularly during periods of distress. Herding behavior involves the tendency of asset managers to move out of a particular security or asset class in a correlated manner. If most large asset managers sell at the same time, the market for that security or asset class may collapse, putting stress on all holders of such assets. As a result of this herding concern, regulators have considered the idea of designating large asset managers as systemically important financial institutions (SIFIs). However, SIFI regulation would likely be unsuccessful in preventing adverse herding behavior.

Keywords:   correlation, financial institutions, herding behavior, asset managers, systemic risk, asset prices

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