What Is Financial Contagion? Causes, Solutions & Examples

Germs are the root cause behind many health issues: Mere microns in size, they invade our bodies and produce toxins that cause disease, making a person very ill. A contagious disease doesn’t just affect one person, though—it spreads from one person to the next, often without their knowing it. For example, according to the U.S. Center for Disease Control (CDC), measles is so contagious that, if one person gets it, 90% of the people they are in contact with will become infected as well.

What Is Financial Contagion? Why Is It Important?

Just like the scientific term, contagion in finance refers to the spread of a problem by indirect or direct contact. The very complex and connective tissues of globalization that power today’s economies are made from a network of resources, materials, manufacturing, and investment. When one aspect of the global economy becomes unstable, it can cause weakness to grow, while damage spreads and quickly amplifies—often with disastrous consequences.

What Are Some Examples of Financial Contagion?

Contagion in finance can be best understood through examples, some of which read more like soap operas than real life.

Asian Currency Crisis

This crisis began with Thailand, which had enjoyed rapid development in the 1980s and 1990s to the tune of 5–10% GDP growth per year, yet its economy was still considered a pretty small player on the world’s stage. Paul Krugman famously compared Thailand’s purchasing power to that of the state of Massachusetts. But Thailand triggered a global set of falling dominoes in 1997 when it devalued its currency, the baht.

Foreign investment had fueled much of Thailand’s rapid boom: Export manufacturers set up new factories, real estate speculation grew, and both private and public capital inflows ballooned to more than $250 billion by the mid-90s.

The Thai government allowed currencies to rise while simultaneously increasing its monetary supplies, which caused credit to expand and fueled even more investment. However, the side effects were steep: Thailand’s debts skyrocketed, and its foreign exchange reserves became depleted, and so when authorities finally took measures to rein in the bubble, investors panicked. Many speculative loans became insolvent, specifically in real estate. Thai equity markets tanked, its banks came under pressure, GDP growth slowed, and a recession was triggered.

But the selloffs spread far beyond Thailand’s borders as investors lost confidence not just in its singular economy but rather in all “emerging market” investments throughout Asia, effectively crippling the economies of Malaysia, the Philippines, as far away as South Korea—and even sparked political unrest in Indonesia.

Financial Crisis of 2007–2008

U.S. subprime mortgages were to blame for a financial crisis of global proportions in 2007 and 2008. Millions of buyers, eager for their chance at the “American dream” of home ownership, took out risky, adjustable-rate mortgages during the height of a housing boom. Many did not understand how the terms of these mortgages would change to the tune of several thousand dollars a month in the event that interest rates went up.

When the Federal Reserve sought to stave inflationary pressures through a series of rate hikes between 2004 and 2006, they unleashed an avalanche: First, homeowners defaulted on their mortgages. At one point nearly 10% of all U.S. mortgages were delinquent or in foreclosure. Next, banks, which had pooled the home loans into interest-bearing securities called collateralized mortgage obligations (CMOs) and traded them with investment banks around the world, would experience the implosion of these toxic debts, leaving many on the brink of insolvency. Finally, overleveraged government-sponsored home ownership enterprises like Fannie Mae and Freddie Mac needed emergency bailouts so that they, too, would not go out of business.

Investment bank Lehman Brothers failed on September 15, 2008, causing the stock market to crash and triggered selloffs around the world, leading to a 2-year recession known as the Great Recession.

Cryptocurrency Contagion

FTX, the third-largest cryptocurrency exchange at its height, went from a $32 billion valuation to declaring bankruptcy over the course of a few days in November 2022, bringing much of the crypto world down with it. After founder and CEO Sam Bankman-Fried admitted to “messy accounting,” the company disclosed a lack of liquidity stemming from depositor withdrawals, as FTX did not have enough reserves to cover them.

The night after Sam Bankman-Fried stepped down as CEO, hackers stole hundreds of millions of dollars of tokens; Bankman-Fried was later arrested on criminal charges of securities fraud and money laundering and extradited to the United States in December, 2022.

The fallout from FTX affected the entire cryptocurrency market as investment firms had put hundreds of millions of dollars into digital tokens, only to watch their value erode as shares of FTX plummeted. Investors, already wary of investing in crypto, became reluctant to re-enter the digital currency markets; in addition, digital currencies are expected to face increased regulation from the Securities and Exchange Commission and other regulatory authorities.

What Are the Causes of Financial Contagion?

“When Paris sneezes, the whole world catches a cold.”
–Klemens von Metternich, 1813

A financial crisis doesn’t always lead to contagion, but in today’s interconnected markets, even when risks are hedged, a shock in one country can trigger a global asset selloff as well as a credit crunch.

After all, the very channels through which financial shocks are transmitted transcend state lines. These channels include trade links, international financial markets, and banking centers, which often hold both domestic and foreign securities.

In the case of the 2007–2008 Financial Crisis, failures in the U.S. subprime mortgage market were transmitted to the rest of the world through bank linkages. In the case of the Asian Currency Crisis, it was trade links: The Thai government attempted to safeguard economic competitiveness by devaluing its currency.

What Are the Effects of Financial Contagion?

Just like its name, the effects of contagion can be widespread. Some of the fallout includes (but is not limited to):

• Financial crises that affect a country’s currency can spillover to other countries as institutional fund managers apply “rules of thumb,” which weakens demand for assets in other parts of the region as well.
• When a financial crisis triggers a loss of confidence in depositor accounts, bank runs may occur. And when hundreds of a bank’s customers simultaneously demand their money back, more often than not, that bank will fail.
• Contagion leads to volatility in equity markets, including selloffs and even capitulation.
• As investors dump shares of toxic assets, they create a “flight to liquidity,” seeking safety in more historically secure investments, such as U.S. Treasury bonds.

How Is Financial Contagion Resolved?

Oftentimes, legislative or regulatory authorities need to step in to stem the hemorrhaging, but it could take years for the entity in crisis to get back on track—if ever.

In the case of the Financial Crisis of 2007–2008, the United States Congress passed the $700 billion Troubled Asset Relief Program (TARP) in 2008. In addition, the Federal Reserve began a series of quantitative easing measures and slashed interest rates to zero for an unprecedented 6-year period between 2008 and 2014 to make banks comfortable lending again.

Are We Experiencing Financial Contagion?

Silicon Valley Bank (SVB) failed on March 10, 2023 and triggered a crisis in confidence in the global banking sector. SVB had invested in bonds when interest rates were low but did not hedge its risks when rates shot up in 2022. In addition, SVB’s customers were startups and technology firms, which had floundered through the COVID-19 pandemic. As these firms needed access to their deposits in order to satisfy customer withdrawal requests, SVB simply could not keep up—and it collapsed.

Signature Bank, located in New York, was next to fall, on March 12.

On March 17, another lender declared itself in crisis, First Republic Bank, and Wall Street titans JP Morgan Chase, Citigroup, and Bank of America, among others, came to its rescue with $30 billion in liquidity. Credit Suisse took a $54 billion lifeline from the Swiss government before being acquired by UBS for $3.2 billion on March 19.

The U.S. government stepped in by guaranteeing deposit accounts at SVB and First Republic, and the Federal Reserve, Department of the Treasury, and Federal Deposit Insurance Corporation (FDIC) released a joint statement of support. They also unveiled a Bank Term Funding Program to allow troubled banks to access loans at par for up to one year. In addition, famed investor Warren Buffett is in talks with the White House about a possible investment in regional banks.

Only time will tell if these actions are enough.

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