Financial Contagion

Contagion is a spread of a disease from one person to another.

While we are facing a deadly Covid virus contagion, there is an equally frightening situation - The Financial contagion. While the former has cost lots of lives, the latter can cause a huge financial loss to the world.

Financial institutions like banks and securities markets are the backbone of the whole economy. They serve as intermediaries that connect borrowers to lenders. Taking the case of a bank, it has a huge responsibility to keep the public deposits safe and provide a stable return. With this huge responsibility, comes a huge risk for them. This risk, popularly known as “systematic risk” cannot be avoided. A bank has to be prepared for it with adequate resources.

Financial contagion is a byproduct of this systematic risk. It can lead to the market downfall from one country to another with the movements in stocks, exchange rates and interest rates. Thanks to global interdependence, many multinational banks have set up their shops in many countries. All of these are favourable factors that promote growth but they can also result in big losses. Even if one bank stumbles on its payments, it has the potential to spread across the world in a short period.

The financial crisis of 2008 is the best example of financial contagion. Banks like Goldman Sachs took the risk of lending more to unprofitable businesses, investing in risky assets than they should have. As soon as businesses and individuals started to fail on their payments, credit risk in the market started to increase and spread across all banks in the world. Post this crisis, the government has set clear rules and minimum capital requirements to be maintained at all times. Bank’s capital is judged under a high-stress scenario, whether it can withstand another crisis or not. They have to be very careful to lend and invest money on only those assets that will guarantee returns without any additional risk.

The post effects of contagion to developing countries is far worse than that of the developed nations. Strong financial regulators and government intervention is required to protect the economy. It is like the house of cards, when one card stumbles, the whole house comes crashing down.

Concept: Shivangi Bhatia

Editor: Minakshi Todi

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