Contagion Effect

Contagion Effect

Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission of a medical disease. Financial contagion happens at both the international level and the domestic level.

At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks. An example of this phenomenon is the failure of Lehman Brothers and the subsequent turmoil in the United States financial markets.

International financial contagion, which happens in both advanced economies and developing economies, is the transmission of financial crisis across financial markets for direct or indirect economies. However, under today's financial system, with large volume of cash flow, such as hedge fund and cross-regional operation of large banks, financial contagion usually happens simultaneously both among domestic institutions and across countries. The cause of financial contagion usually is beyond the explanation of real economy, such as the bilateral trade volume.