What is financial contagion?

• A. The spread of financial distress from one market or institution to others
• B. The risk that a single bank fails
• C. The regulation of financial markets
• D. The difference between a market order and a limit order

Answer: (A)

Financial contagion is the spread of financial distress from one market or institution to others. When trouble hits a major firm or a funding market tightens, banks and investors may pull back, funding costs rise, asset prices fall, and losses ripple through counterparties and even unrelated markets. This propagation happens through interconnected balance sheets, common exposures, and psychology-driven reactions, creating a feedback loop that amplifies the initial shock. An example is a funding shock to banks that causes liquidity to dry up, leading to tighter credit conditions and asset price declines across the system, even for entities with solid fundamentals. This is different from the risk that a single bank fails on its own, which is more about idiosyncratic risk. It’s also not about regulation or simply the mechanics of trading orders, which don’t describe how distress spreads through the financial network.