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Financial contagion is the spread of negative effects from one financial institution or market to others. It can be caused by events such as currency devaluations, economic recessions, and bank failures. The interdependence of world markets means that no financial crisis can be confined to its own country or industry. Governments have established controls to mitigate the effect, such as bank deposit insurance and financial regulations.
Financial contagion refers to the decline in the condition of a financial institution or market that causes 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 disease. It is only since the turn of the century that disparate financial conditions have been analyzed in terms of contagion rather than isolation. With the world more interdependent than ever, it is easier for theorists to try to demonstrate the relationship of successive financial shocks at the national and international levels.
The types of events that are typically analyzed in terms of financial contagion are currency devaluations, economic recessions, and bank failures. In 2010, for example, the financial crisis in Greece, where a European Union bailout was needed to prop up the country’s economy, was thought to have a contagious impact on the US housing market. Analysts made a connection between the crisis undermining investor confidence and leading them to reorganize investments in US Treasury bonds, which are considered the safest form of investment worldwide. Since mortgage interest rates in the United States are tied to Treasury rates, the impact of increased investment in that type of security reportedly had a ripple effect on real estate sales.
Financial contagion is also analyzed in a domestic context. The banking crisis in the mid-2000s in the United States, for example, seemed to start with the failure of a major investment bank. Banks then defaulted 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 interdependence of world markets means that no financial crisis can necessarily be confined to its own country or industry.
There are a number of popular economic theories that attempt to explain the basis of the phenomenon of financial contagion. Some think that multi-currency dependencies or links between financial institutions drive contagion. Others focus on cross-border market interdependencies to explain successive effects. A common sense approach is to look at the human psychology that causes people to react out of fear and generate a transaction impulse that cannot be stopped by public guarantees.
The concept of financial contagion has caused governments to establish controls to mitigate the effect. Bank deposit insurance is an example of a government attempt to prevent foreclosures of bank customers that could result from a bank failure. Financial regulations were also put in place to control pollution from an entire industry by establishing checks and balances to prevent non-compliance. These types of government actions have the basic objective of maintaining public confidence in financial institutions and the economy.
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