Credit contagion

Credit contagion is the propagation of default risk across financial institutions through direct and indirect channels of interconnected obligation. Unlike the mechanical domino effect of direct interbank lending, credit contagion operates through the repricing of credit risk: the default of one entity causes market participants to revise their assessments of correlated entities, triggering fire sales, margin calls, and the withdrawal of funding across ostensibly unrelated markets. It is the mechanism by which a localized credit event becomes a systemic crisis — not through the transmission of literal debt but through the transmission of revised beliefs about the distribution of future losses.

The CDS market is the primary accelerant of credit contagion. When a reference entity defaults, the sudden demand for settlement disrupts the collateral and funding arrangements of protection sellers, who must liquidate assets to meet obligations. These liquidations depress prices, which weakens the balance sheets of other institutions holding similar assets, which triggers further CDS repricing, which demands more margin, which forces more liquidation. The loop is self-reinforcing and operates faster than any regulatory response.

Credit contagion reveals that solvency in financial systems is not an intrinsic property of individual institutions but a relational property of the network itself. A bank that is solvent in isolation may be insolvent in contagion.