What Is Financial Contagion During an Economic Crisis?

What Is Financial Contagion?

Financial contagion is the spread of an economic crisis from one market or region to another and can occur at domestic and international levels. The contagion can affect goods and services, labor, and capital goods used across markets connected by monetary and financial systems.

The 1997 Asian financial markets crisis was among the first examples of the term being used. The real and nominal interconnections of markets can propagate and even magnify economic shocks, likening the effect to the spread of disease like a contagion.

Key Takeaways

  • Financial contagion is the spread of an economic crisis from one market or region to another and occurs at a domestic or international level.
  • Events in one market can impact other markets.
  • Strong markets can buffer economic shocks, while fragile markets can magnify negative shocks.
  • Contagion can be seen during credit bubbles and financial crises.

Understanding Financial Contagion

Financial contagion is defined as a shock that initially affects a few financial institutions and spreads to the rest of the financial system, commonly infecting the economies of other countries. Contagions are typically associated with the diffusion of crises throughout a market, asset class, or geographic region. A similar effect can occur with economic booms. The phenomenon of financial contagion has implications for portfolio management, trading, hedging, and diversification strategies.

Why Does Financial Contagion Occur?

Markets in a domestic and global economy are interconnected. From the consumer side, many consumer goods are substitutes or complement one another. From the producer side, the inputs for any business can be substitutes and complements for one another, and the labor and capital that a business requires may be used in different types of industries and markets.

Economies rely on financial institutions to facilitate the flow of goods and services through the economy. Any instability that occurs in these entities can spread throughout countries via the balance sheets of financial intermediaries. Damage to the balance sheet of a bank or leveraged financial institution can trigger a selloff of assets or a recall of cross-country loans. 

Vulnerability of Economies to Financial Contagion

When markets are fragile, a strong negative shock in one market can not only cause that market to fail but spread damage to other markets and, perhaps, the entire economy. Markets that depend on debt, a specific commodity, or where conditions prevent the smooth adjustment of prices and quantities, entry and exit of participants, and adjustments to business models or operations will be more fragile and less flexible.

With increased global lending through cross-border loans, there is economic efficiency and growth but a higher risk of contagion. Short maturities of bank debt further increase vulnerability. Countries with better-capitalized banking systems that finance credit to a larger degree by deposits have proven less vulnerable to contagion. 

Examples of Financial Contagion

The 1997 Asian financial markets crisis, the Great Depression, the financial crisis of 2007-2008, and the COVID-19 pandemic are examples of the effects of financial contagion in an economically integrated global economy. After the Asian financial crisis, scholars investigated how financial crises spread across national borders, and they concluded that the "nineteenth-century had periodic international financial crises in virtually every decade since 1825."

The COVID-19 pandemic has proven to have a global impact on economies, markets, industrial sectors, and attitudes toward financial risk, international trade, and corporate practices. The term, contagion, captures the spread of the infectious disease, as well as the transmission of social, financial, and economic impacts across borders. 

On March 10, 2023, Silicon Valley Bank failed after a bank run, marking the second-largest bank failure in United States history and the largest since the 2008 financial crisis, and federal regulators implemented measures to prevent financial contagion.

What U.S. Agencies Provide Guidance and Policy During a Financial Crisis?

The Federal Reserve Chair, the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC), and banking regulators assemble policy and guidance during a financial crisis in the United States.

What Aid Does the FDIC Provide During a Period of Financial Contagion?

The Federal Deposit Insurance Corporation (FDIC), formed following the Great Depression, insures the bank deposits of individuals of up to $250,000 should a financial crisis occur.

What Is the Bank Term Funding Program?

The Bank Term Funding Program (BTFP) was created in March 2023 following the collapse of Silicon Valley Bank. To prevent panic and financial contagion, it makes additional funding available to eligible depository institutions to help assure banks can meet the needs of all their depositors. The BTFP offers loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions. 

The Bottom Line

Financial contagion is the spread of an economic crisis from one region to another and can occur at domestic or international levels. The term was first coined during the 1997 Asian financial markets crisis. The Great Depression, the financial crisis of 2007-2008, and the COVID-19 pandemic are examples of financial contagion in an economically integrated global economy that depends on shared financial institutions.

Article Sources
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  2. Duke University. "Financial Contagion During the COVID-19 Pandemic."

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