The three C’s of systemic risk Connectedness, Contagion, and Correlation

The three C’s of systemic risk are Connectedness, Contagion, and Correlation. Systemic risk can increase because institutions are tied structurally through funding, common portfolios, and behavior. 

Connectedness is about the plumbing. It is also about the rules of the game. Regulation can increase or decrease connectedness. 

Contagion is when an event sweeps across institutions that may not be connected. It is a behavior issue. It usually cannot occur if there is no connectedness. Herding will occur during a crisis as expectations condense into specific common beliefs. 

Correlation is the result of connectedness and contagion. If there is a crisis, we know that correlations will increase and trend to 1. There is a common view and common behavior. We will not know how much connectedness or contagion will exist until we see the correlations across markets rise. 

Any discuss about systemic risk should thinking about the 3 C's. Any discussion concerning the prevention of systemic risk or crisis will try and answer what may happen with the 3 C's.