What Is Financial Contagion?

Financial contagion refers to the declining condition of one financial institution or market that prompts similar negative effects in unrelated institutions or markets. The phenomenon is often compared to the spread of a disease because it seems to be “caught” by other entities like a sickness. It is only since the turn of the century that disparate financial conditions have been analyzed in terms of contagion instead of in isolation. With the world more interdependent than ever, it is easier for theorists to try to prove the relatedness of successive financial impacts domestically and internationally.

The types of events that are ordinarily analyzed in terms of financial contagion are currency devaluations, economic recessions, and bank failures. In 2010, for instance, the financial crisis in Greece, where a European Union bailout was needed to shore up the country's economy, was thought to have a contagious impact on the US real estate market. Analysts made a connection between the crisis undermining investor confidence, leading them to rearrange investments into US Treasuries which are considered worldwide to be the safest form of investment. Since mortgage interest rates in the US are tied to Treasury rates, the impact of an increase in investment in that type of security supposedly had a ripple effect on real estate sales.

Financial contagion is also analyzed in a domestic context. The banking crisis during the mid-2000s in the US, for instance, seemed to start with the failure of one major investment bank. Thereafter, banks fell into default like dominoes until the government stepped in with a bailout package. By then, however, the financial crisis seemed to have spread to the UK and other countries. The interdependency of world markets means that no financial crisis can necessarily be restricted to its own country or industry.

There are a number of popular economic theories that try to explain the basis of the financial contagion phenomenon. Some think that the dependencies of various currencies or the linkages between financial institutions drive the contagion. Others focus on cross border market interdependencies to explain the successive effects. One common sense approach is to look to human psychology that causes people to react out of fear and generate transaction momentum that cannot be halted by public assurances.

The concept of financial contagion has caused governments to put controls in place to mitigate the effect. Bank deposit insurance is an example of a government attempt to prevent customer runs on banks that could result from the failure of one bank. Financial regulations were also put in place to control pollution of an entire industry by establishing checks and balances to prevent defaults. These types of governments actions have the basic goal of maintaining public confidence in financial institutions and the economy.