Financial contagion refers to the process by which a crisis that begins in one region or country spreads to an economically linked region or country. Sometimes the basis for contagion is provided by information. Kodres and Pritsker (2002), Calvo and Mendoza (2000a, b) and Calvo (2002) show how asymmetric information can give rise to contagion between countries that are affected by common fundamentals. An example is provided by asset markets in two different countries. A change in prices may result from a common shock that affects the value of assets in both countries or it may result from an idiosyncratic shock that either has no effect on asset values (a liquidity shock) or that affects only one country. Because the idiosyncratic shock can be mistaken for the common shock, a fall in prices in one country may lead to a self-fulfilling expectation that prices will fall in the other country. In that case, an unnecessary and possibly costly instability arises in the second country because of an unrelated crisis in the first.
A second type of contagion is explored in this chapter. The possibility of this kind of contagion arises from the overlapping claims that different regions or sectors of the banking system have on one another. When one region suffers a banking crisis, the other regions suffer a loss because their claims on the troubled region fall in value. If this spillover effect is strong enough, it can cause a crisis in the adjacent regions. In extreme cases, the crisis passes from region to region, eventually having an impact on a much larger area than the region in which the initial crisis occurred.
The central aim of this chapter is to provide some microeconomic foundations for financial contagion. The model developed below is not intended to be a description of any particular episode. It has some relevance to the recent Asian financial crisis. For example, Van Rijckeghem and Weder (2000) consider the interlinkages between banks in Japan and emerging countries in Asia, Latin America, and Eastern Europe. As one might expect, the Japanese banks had the most exposure in Asian emerging economies. When the Asian crisis started, in Thailand in July 1997, the Japanese banks withdrew funds not only from Thailand but also from other emerging countries, particularly from countries in Asia, where they had the most exposure. In this way, the shock of the crisis