Glossary term
Contagion Risk
Subject: Risk Management, Strategic and Systemic Risk
Also known as: Spillover risk
Contagion risk is the risk that distress at one firm, market or country spreads to others through links such as shared exposures, funding ties, confidence or common assets.
Explanation
Several channels carry it. Direct exposure is one, such as a bank lending to a failed counterparty. Common holdings are another: forced sales of one asset push down its price for everyone who holds it. Funding dependence is a third, where lenders pull back from every firm that looks similar. Confidence is the fourth, as news of trouble at one firm makes customers or investors doubt others. Runs on deposits and sharp moves across markets are typical results. Contagion can also pass inside a group, from one subsidiary to another, or through a shared supplier in a business setting. Regulators respond with limits on exposures between institutions, capital and liquidity buffers, central clearing, and resolution plans that let a failing firm be wound down without panic. Contagion is one route by which systemic risk spreads; the two are not the same thing. Supervisors map links between institutions for this reason: a failure of modest size can travel far through dense connections.
Example
A small lender fails, and its depositors are told that losses are possible. Customers of two similar lenders, with no link to the first, queue to withdraw money the next day after seeing alarming social media posts. Both face a run despite being sound. The central bank announces liquidity support, which stops the spread.
Not to be confused with
- Systemic Risk
- Systemic risk is the danger of the whole system failing; contagion is one way distress travels between parts and can lead there.