Do you know what Contagion effect is?

The dictionary meaning of contagion is the spreading of a particular disease by someone touching another person who is already affected by the disease. Similarly, in financial parlance contagion effect is defined as the spread of an economic crisis from one region to another.

The financial markets and their roles include the stock market, the bond market, forex, commodities, and the real estate market, among others. Financial markets can also be broken down into capital markets, money markets, primary vs. secondary markets, and listed vs. OTC markets. Financial links come from financial globalization since countries try to be more economically integrated with global financial markets.

Financial contagion happens at both the international level and the domestic level. The risk of contagion in banking is referred to as systemic risk. That is the risk that financial difficulties at one or more bank(s) spill over to a large number of other banks or the financial system as a whole. Contagion can spread either through the information channel or the credit channel. 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 in the same country. However, financial contagion can be a potential risk for countries that are trying to integrate their financial system with international financial markets and institutions. The recent incident in the US commercial real estate market is evidence of how domestic contagion moved to international financial Contagion. The US real estate market has been in turmoil since the onset of the Covid-19 pandemic. New York Community Bancorp has decided to slash its dividend and stockpile reserves sending its stock down a record 38% and dragged the KBW Regional Banking Index to its worst day since the collapse of Silicon Valley Bank last March. Tokyo-based Aozora Bank plunged more than 20% after warning of a loss tied to investments in US commercial property. In Europe, Deutsche Bank AG more than quadrupled its US real estate loss provisions to €123 million ($133 million) in the fourth quarter from a year earlier. Banks are facing roughly $560 billion in commercial real estate maturities by the end of 2025, according to Trepp a leading provider of data, insights, and technology solutions to structured finance, and commercial real estate, representing more than half of the total property debt coming due over that period. Regional lenders in particular are more exposed to the industry, and stand to be hurt harder than their larger peers because they lack the large credit card portfolios or investment banking businesses that can insulate them.

Under today’s financial system, with the large volume of cash flow, such as hedge funds and cross-regional operation of large banks, financial contagion usually happens simultaneously both among global and domestic institutions. With increasing interdependence and correlation between economies, the possibility of the Contagion effect has increased.

While internationally, there could be several other factors governing trade, which may influence the extent of this contagion effect across geographies. Although a direct relationship may not be apparent, it’s the ripple effects from a small market disruption that can transcend into different asset classes and financial markets that can trigger larger risk events leading to systemic risk affecting all economies. For example, the term Financial Contagion was first coined during the 1997 Asian financial markets crisis. On July 2, 1997, the central bank of Thailand devalued their currency Baht. This caused a chain reaction of falling stock markets and asset price devaluations as private debt exploded throughout Asian markets from South Korea, Philippines, Laos, and Malaysia to Singapore, Taiwan, Vietnam, Indonesia to Japan, Hong Kong, and even mainland China and eventually leading to a U.S. stock market crash four months later.

The sub-prime crisis in the US is another example of financial Contagion. The subprime mortgage crisis in 2007-2008 was triggered by risky lending practices. When interest rates froze and the housing bubble began to collapse, borrowers couldn’t afford their payments. As massive foreclosures ensued, the fallout spread to the global financial system including the capital market.

The fundamental underlying above scenarios where price movements in one market are resultant of shocks or volatility in the other market is that there is a perfect information flow.  The spread of market disturbances is due to co-movements in exchange rates, stock prices, sovereign spreads, and capital flows.

Some examples of financial markets and their roles include the stock market, the bond market, forex, commodities, and the real estate market, among others.  How these markets get contagious due to interconnectedness is explained in our following articles. Read them to learn more.

1. EXPLAINED: INTERCONNECTEDNESS OF CREDIT MARKET

2. BENEFITS AND RISKS OF INTERCONNECTEDNESS OF BANKS

3.. INTERCONNECTEDNESS OF THE MONEY MARKET

4. INTERCONNECTEDNESS OF THE CAPITAL MARKET

5. VOLATILITY AND INTERCONNECTEDNESS OF THE FOREIGN EXCHANGE MARKET

6. INTER CONNECTEDNESS OF FINANCIAL MARKETS

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