Contagion: a misnomer for financial crisis

It has become commonplace to call the financial institutions at the centre of the most recent financial crisis ‘too big to fail’. This is a misnomer, as institutional size simply happens to be correlated with what really matters: interconnectedness. A big bank that operates in a vacuum is a danger only to itself and its immediate creditors. If it assumes too much risk, it will fail, and the economy will continue to function, uncontaminated by this failure. Indeed, many would see that failure as a net benefit, correctly punishing an entity that was making bad decisions. However, if that financial institution is interconnected with other important institutions—through direct investment, counterparty risk or special protections from governments or central banks—then the failure of a single institution may catalyse a system-wide catastrophe. The central role of interconnectedness makes it attractive to employ metaphors drawn from the realm of infectious disease when describing financial crises—indeed, as I write this, a recent deal to save Cypriot banks has been described as having ‘proved that “contagion” from one country to another can be contained’. However, as Robert Peckham observes, analogies between financial crises and epidemics of infectious disease frequently involve mistranslations and ‘critical distortions’. The spread of financial panic may look similar to the transmission of infectious disease among and between human populations, but the superficial similarities hide important differences. ‘Contagion’ is as much a misnomer as ‘too big to fail’.