What it means
There are two broad channels, and separating them helps a great deal when assessing risk. Direct contagion runs through balance sheets, so that when one firm cannot pay, its counterparties take a real loss and their own creditors may then be short.
Indirect contagion runs through information and confidence instead. When one regional lender fails, depositors at similar lenders start asking whether their own money is safe, and the resulting withdrawals can bring down a bank that was solvent an hour earlier.
Forced selling ties the two channels together. An institution absorbing losses often has to sell its most liquid assets to raise cash, which pushes down the price of those assets for everyone holding them and creates fresh losses at firms with no connection to the original problem.
For ordinary businesses the relevance is concentration. A company with one dominant customer, one lender or one payment processor is exposed to that counterparty's counterparties as well, which is why spreading banking and supply relationships is a genuine risk control rather than an administrative chore.
Regulators try to interrupt the chain rather than prevent every failure. Capital buffers, central clearing, deposit insurance and lender of last resort facilities all exist to stop one failure automatically becoming several, which is why the word appears so often in policy documents.
In practice
Real-world examples
Example 1
A currency crisis in one emerging market prompts fund managers to cut exposure across the whole region. Bond yields rise in neighbouring countries with healthy public finances simply because they sit in the same index.
Example 2
A commercial property lender announces heavy write-downs and its share price halves. Within days, shares in three unrelated lenders with property books fall between 15% and 25% as investors reprice the sector rather than the individual companies.
Example 3
A payments processor collapses and freezes settlement for two days. Several small online retailers with no financial link to it miss supplier payments, because their cash was sitting in the processor's account rather than in their own.
Think of it
Contagion is like a row of dominoes. When one piece falls over, it hits the next one, and the motion spreads quickly down the line, even to pieces that were initially standing far away from the source.
Formula
Calculation
Direct loss to a counterparty = exposure x (1 - recovery rate)
Capital after loss = capital before loss - direct loss
A mid-sized bank has $250,000,000 of unsecured exposure to a trading counterparty that fails. Administrators expect a recovery of 60 cents in the dollar, so the loss is $250,000,000 x (1 - 0.60) = $250,000,000 x 0.40 = $100,000,000.
The bank held $400,000,000 of core capital, which falls to $400,000,000 - $100,000,000 = $300,000,000, a reduction of $100,000,000 / $400,000,000 = 25%. Against risk weighted assets of $4,000,000,000, its capital ratio falls from $400,000,000 / $4,000,000,000 = 10% to $300,000,000 / $4,000,000,000 = 7.5%.
That is where contagion begins rather than ends. To rebuild the ratio to 10% without raising new capital, the bank must shrink risk weighted assets to $300,000,000 / 0.10 = $3,000,000,000, which means withdrawing $1,000,000,000 of lending from borrowers who had nothing whatever to do with the original failure.Case study
Seen in the real world
The following is an illustrative and entirely fictional scenario. Trellin Capital, an invented specialist lender funded largely by short term wholesale borrowing, announced that $180,000,000 of its $900,000,000 loan book was impaired, wiping out 20% of the portfolio's value and most of its equity.
Within a week three other invented lenders with similar funding models found their own borrowing costs rising. Ashgrove Mutual, which ran a conservative book and had no exposure to Trellin at all, saw the rate on its rolling wholesale funding move from 4.2% to 6.8%. On $1,500,000,000 of borrowing that is an extra $1,500,000,000 x 2.6% = $39,000,000 of annual interest, set against pre-crisis profit of $52,000,000.
Nothing about Ashgrove's loans had changed, yet 75% of its profit had evaporated because of a firm it had never traded with. In this illustrative story the contagion stopped when the central bank opened a funding facility, which is the standard remedy: break the link between one firm's failure and everyone else's cost of money.
Watch out
Common mistakes
- Assuming contagion requires a direct financial link, when most of it travels through confidence, forced selling and shared funding markets.
- Believing that holding many different assets protects you, when correlations rise sharply in a crisis and previously unrelated holdings fall together.
- Treating contagion as a banking-only problem, when supply chains, insurance markets and payment systems transmit shocks in exactly the same way.
Questions
People also ask
What is the difference between contagion and a normal market correction?
A correction reprices assets on new information about those assets, while contagion spreads losses to assets whose own prospects have not changed at all.
Can contagion be predicted?
Not reliably in its timing, but the exposures that carry it are visible in advance: concentrated funding, short term borrowing against long term assets, and heavy reliance on a single counterparty.
What can a small business do about it?
Spread banking and payment relationships across more than one provider, keep a cash buffer outside the main operating account, and know which customers depend on the same few lenders.