Financial Contagion during the COVID-19 pandemic

By | June 16, 2020

Financial contagion is traditionally defined as a situation in which a shock that initially affects only a few financial institutions spreads, or spills over, to the rest of the financial system and the economy, subsequently infecting the financial systems and economies of other countries. Because of its clear importance to the global economy, this phenomenon is one of the most widely researched areas of finance and has implications for portfolio management, trading, hedging, and diversification strategies.

The Global Financial Crisis provided myriad examples of how contagion spreads. Like a physical disease, contagious financial panics hurt not just those directly affected, but the entire system. But beyond tangible financial connections, contagion can be thought of as excess correlation, or asset co-movements over and above the amount justified by economic fundamentals. Seeing contagion in this way, as something beyond just economic and financial fundamentals, suggests a relationship with a wide variety of aggregate groups: markets, industrial sectors, economies, countries and regions, and the world. Indeed, with the advent of the Internet, the role of media, particularly social media, is progressively important in the transmission of financial and economic shocks across borders.

There is strong evidence that the financial market reverberations of pandemics can last for decades. COVID-19 has been more global and severe in its impact than even the Global Financial Crisis, and it will have a lasting effect on not just economies, markets, and industrial sectors, but also on fundamental attitudes toward financial risk, international trade, firm-level practices, and institutional designs. It is natural then, to consider that COVID-19 will necessitate a revisiting and reconsideration of all aspects of financial contagion research.

The use of the term “contagion” in the analysis of spillovers of crisis shocks across borders has never been as appropriate as in the case of the COVID-19 pandemic. This term captures the spread of the infectious disease itself, as well as the transmission of social, financial, and economic impacts across borders. With a rapidly growing number of empirical papers assessing the financial effects of COVID-19 pandemic, there is a pressing need for a study summarizing the existing knowledge of contagion phenomenon.

In our recent paper, we review existing literature on financial contagion in the context of the unique characteristics of the COVID-19 crisis. This leads to the introduction of a novel conceptual framework of financial contagion, with recommendations for future research in this area.

How is COVID-19 different from the past crises?

The economic impact of the COVID-19 pandemic has been compared with the Great Depression in the 1930s in the US, and its financial effects have been likened to the Global Financial Crisis of 2007–2009 (“GFC”), generating debates over whether it can be considered a “black swan” event. Either way, COVID-19 is undoubtedly spurring drastic action. The US, for instance, is undertaking a $2.2 trillion bailout package (versus a $750 billion package during the GFC). Unlike global nuclear conflict, or perhaps the larger consequences of climate change, COVID-19 is both massive and immediate, and yet survivable and manageable. Hence, financial planning by individuals, private firms, non-profits, and public entities will  adapt in response.

The COVID-19 pandemic has several unique characteristics that distinguish it from previous crises, and which open a new avenue for research of financial interconnectedness and contagion. First, unlike other recent financial contagion events, it is possible to timestamp the crisis and identify its main catalyst. Analyses of the 1997 Asian financial crisis highlighted that one of the main challenges in detecting contagion is the lack of clear catalyst driving the respective turmoil. In the GFC, there were many structural problems in the economy that signalled an impending crisis, such as increasingly short maturity, borrowing by banks to buttress a credit boom, and the overall leverage position of companies and households. However, in 2020 we did not observe such typical early warning signals; rather, the main catalyst of the contagion was the COVID-19 virus itself. While there are a range of views, we can attempt to model of a clear timeline of the virus’s spread across regions and countries, while recording relevant government responses to the pandemic.

Second, COVID-19 differs from previous episodes of financial contagion in the speed of the transmission of the crisis and recovery. We can expect both quicker escalation of the COVID-19 crisis and quicker recovery than previous crises. For example, the dramatic increase in the unemployment rate caused by the COVID-19 crisis was mainly due to the lockdown and social distancing, and when SMEs re-open after the lockdown, we should expect to observe a drop in unemployment in a relatively short period of time.

Third, the COVID-19 pandemic demonstrates heterogeneity in reactions and recovery patterns not only across asset classes, but also within them. Our recent paper analyses the reaction and recovery of four broad classes of financial assets: equity indexes, precious metals, 10-year benchmark bonds, and cryptocurrencies to the progress of the COVID-19 pandemic. It is clear that some financial markets will be less affected by COVID-19 or recover much more quickly than others. For example, while gold offers limited mean reversion, platinum shows very strong resistance to COVID-19. Similarly, while government bonds show small declines in value to COVID-19, in addition to high persistence, cryptocurrencies as a group turn out to be the riskiest in the long-term, with more than a 50% decline in value coupled with high degrees of persistence.

Finally, during past crises episodes, social media played a much less important role in forming public opinion and in pressuring governments, and shaping investors’ expectations. This time, transmission of information via media channels will be more significant for facilitating the response to the crisis and function as one of the main determinants of spillovers in financial markets.

How to analyse the contagion effect of black swans?

While COVID-19 is unique in terms of how it has manifested simultaneously as a global health and economic crisis, it should not have been unexpected. Neither should we assume that similar events in the future are so unlikely that we should not be concerned. It is noteworthy that there have been many recent cases of infectious disease breakouts that could well have turned into pandemics but did not. According to the Global-Preparedness-Monitoring-Board, during 2011–2018 the World Health Organization tracked 1,483 epidemic events in 172 countries. However, our review of the contagion literature showed that the financial effects of past pandemics, i.e. Ebola virus in 2014, SARS virus in 2003, and the earlier occurrence of the Spanish flu in 1918, have been largely under-researched.

We suggest that contagion can be assessed by analysing four main channels of information transmission driving the spread of the crisis across region and countries: (i) analysis of the main catalyst of contagion; (ii) transmission of information via international media and social media; (iii) assessing the spillover effects on financial markets; and (iv) contagion through macroeconomic fundamentals.

The first level is analysis of the main catalyst of contagion, i.e. the variable related to the specific event that played a catalysing role in starting the contagion. The “black swan” metaphor is used in finance to describe unpredicted shocks that occur rarely and cause major effects on financial markets and the economy, demonstrating the failure of standard tools and techniques to predict the dynamics of the crisis and changing the expectations and risk perceptions of the main actors. This metaphor has been employed previously with regards to the GFC, as well as in studies of technological innovations, sudden increases in the US LIBOR spread, China’s stock market crash of 2015, and federal policy changes, to name but a few. There is ongoing debate whether ‘black swan’ is a suitable metaphor for the COVID-19 pandemic. We believe that COVID-19 can be considered a black swan event, since the spread of the pandemic resulted in extreme measures of social distancing and government restrictions on a scale that has not occurred in recent history.

Black swan events attract attention from the public and the media, resulting in higher (social) media engagement and discussion. Thus, information regarding the catalyst of contagion is quickly picked up by the media and transmitted widely, causing an information cascade to all actors and parties, including local and national governments, NGOs, and businesses. As governments and other actors react quickly to tackle crises and issue relevant directives, financial contagion is accelerated.

In the context of psychology studies, the term “contagion” has also been used to refer to how both positive and negative emotions can be contagious in humans. However, the term “emotional contagion” is not yet widely used in financial contagion literature. This may change as additional research on financial market sentiment unfolds. We do have some evidence that contagion spreads to those assets named “corona” which sound like they are part of the pandemic, even if not. Psychological and emotional biases, and the world of finance, are bridged by behavioural finance literature. A recent study examines herding behaviour in cryptocurrency markets during COVID-19, and its results suggest that cryptocurrency herding was conditioned to up and down market movements, but not necessarily amplified by the pandemic.

Financial markets participants will be the first to react to all the negative news and stories appearing in the media. Therefore, financial markets spillovers are the next channel of contagion to study. The literature on this is extremely large since the majority of contagion papers utilize a narrow definition of contagion in which there are increases in spillover effects between financial markets following a crisis shock in a particular market.

Finally, while crisis shocks will be reflected in macroeconomic fundamentals, it will take longer to observe these changes in comparison to financial asset prices. COVID-19 presents a macroeconomic shock that has not been particularly localized (except perhaps momentarily in China). Instead it has extended over the world, largely because of social distancing requirements. While some countries, Nigeria or India for example, may ultimately experience less health impacts from COVID-19, implementation of social distancing along with global interlinkages of supply chains and trade suggest that all nations will be severely economically impacted by COVID-19.

Research on financial contagion in the near future will be particularly vital and relevant. Our proposed framework will help researchers to conduct more coherent and rigorous research and produce meaningful findings.

Recommendation for future research

Future pandemics on the scale of COVID-19 will no longer be dismissed by financial markets as being improbable. Therefore, it is important to consider how catalysts and mechanisms related to contagion might be either exacerbated or dampened during COVID-19 or similar pandemics. Pandemics such as COVID-19 might also change the conditions for future financial contagion.

The effects of COVID-19 strengthen the need to reconsider several catalysts and mechanisms of financial crises and subsequent contagion. These effects include a global impact rather than a local impact; a dramatic and temporary decline in global domestic demand; a marked downturn in enthusiasm for leverage by both firms and households (even as greater borrowing may be a temporary exigency); an increased risk perception of equity markets; and an increase in the stress on banking solvency in developing countries. By extension, in the future, it is reasonable to expect that fears of pandemics, due to a discovery of new cases or a new disease etc., will almost certainly lead to quick and severe global financial impacts. Future research will consider whether to regard these events as either extremely fast contagion or, alternatively, as simultaneities. In some ways, COVID-19 will leave the world less globalized, with countries working to be able to close borders rapidly. But in other ways, COVID-19 will engender the world to become more keenly aware of the need to coordinate activity with regard to preventions of global natural disasters, and preparations against pandemics will be seen as a global public good.

While differences across regions can always be found if we look closely enough, the unprecedented global nature of COVID-19 presents a new view of how financial crises might or might not spread. During truly global crises, many previously identified financial transmission mechanisms between haves and have-nots are likely less relevant than they would have been under more localized crises. The transference of liquidity for instance, through dividends or stock sales, is less likely if all countries are being impacted, as opposed to just a handful.

Regarding sharp declines in global domestic demand, future research will need to consider how this impacts the potential for financial and economic crises. Research shows that household credit booms take a prominent role in driving financial crises and recessions. How will an ongoing reduction in domestic demand impact the likelihood of household credit booms? Certainly there may be considerable need for additional borrowing during economic crises. But will households be so shaken by COVID-19 as to permanently adjust personal savings rates? If so, how will this impact the potential for future financial contagion?

On the equity side of firm financing, COVID-19 clearly suggests a previous under-pricing of equity risk. Will there be permanent increase in costs of equity? Previous studies report a two-percentage point increase in the country risk premium for China and Hong Kong following SARS. All else equal, such an increase in country risk premiums will lead to significant increases in costs of equity. Consequently, COVID-19 may bring to the global collective consciousness a new assessment of global risks. The findings of increased country risk for China and Hong Kong are based on their particular local exposure to SARS. With a genuine pandemic like COVID-19 however, the exposure is global rather than in select countries. How will COVID-19 impact attitudes toward equity risk and how will this change in risk perception shape equity market bubbles, crises, and contagion?

For a full list of recommendations for COVID-19 research, please refer to our recent paper. Overall, we offer both suggestions for future research vis-à-vis COVID-19 and financial contagion, as well as a framework for regarding financial contagion research in the COVID-19 and post-COVID-19 world.


Larisa Yarovaya is a Lecturer in Finance, and Programme Director of BSc Finance within Southampton Business School at the University of Southampton. John W. Goodell is an Associate Professor in the Department of Finance at the University of Akron.  Brian Lucey is a Professor in the Business School at Trinity College Dublin. This post is adapted from their new paper, “Rethinking Financial Contagion: Information Transmission Mechanism During the COVID-19 Pandemic,” available on SSRN.

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