Correlated Assets and Contagious Defaults

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 determins 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 probalility of a systemic crisis is hump-sharped; in particular, lowering the correlation between the assets returns of different banks does not always imply a lower probability of a systemic crisis.