What is correlation risk primarily associated with?

Correlation risk is primarily associated with the potential of multiple bank loan defaults occurring simultaneously. This concept refers to the risk that the performance of various assets, such as loans or investments, may become more tightly linked during periods of market stress or financial crisis.

When multiple borrowers are affected by similar conditions—like economic downturns or industry-specific challenges—the likelihood of defaults increases simultaneously, leading to significant losses for financial institutions and investors. This risk becomes crucial to understand, especially in the context of portfolios containing different loans or securities, as it highlights the interconnectedness of risks and the cascading effects that can occur when correlations increase.

Understanding correlation risk is essential for managing credit risk in portfolios and attempting to mitigate potential collective defaults, which can amplify losses beyond what might be expected from individual loan performance alone.