Financial contagion refers to "the spread of market disturbances—mostly on the downside—from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows". Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.

Financial contagion happens at both the international level and the domestic level. At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks. An example of this phenomenon is the subsequent turmoil in the United States financial markets. International financial contagion, which happens in both advanced economies and developing economies, is the transmission of financial crisis across financial markets for direct or indirect economies. However, under today's financial system, with the large volume of cash flow, such as hedge fund and cross-regional operation of large banks, financial contagion usually happens simultaneously both among domestic institutions and across countries. The cause of financial contagion usually is beyond the explanation of real economy, such as the bilateral trade volume.

The term financial contagion has created controversy throughout the past years. Some argue that strong linkages between countries are not necessarily financial contagion, and that financial contagion should be defined as an increase in cross-market linkages after a shock to one country, which is very hard to figure out by both theoretical model and empirical work. Also, some scholars argue that there is actually no contagion at all, just a high level of market co-movement in all periods, which is market "interdependence".

More generally, there is controversy surrounding the usefulness of "contagion" as a metaphor to describe the "catchiness" of social phenomena, as well as debate about the application of context-specific models and concepts from biomedicine and epidemiology to explain the diffusion of perturbations within financial systems.

Financial contagion can create financial volatility and can seriously damage the economy and financial systems of countries. There are several branches of classifications that explain the mechanism of financial contagion, which are spillover effects and financial crisis that are caused by the influence of the four agents' behavior. The four agents that influence financial globalization are governments, financial institutions, investors, and borrowers.

The first branch, spill-over effects, can be seen as the negative externalities. Spillover effects are also known as fundamental-based contagion. These effects can happen either globally, heavily affecting many countries in the world, or regionally, affecting only neighboring countries. The big players, who are more of the larger countries, usually have a global effect. The smaller countries are the players who usually have a regional effect. "These forms of co-movements would not normally constitute contagion, but if they occur during a period of crisis and their effect is adverse, they may be expressed as contagion."

"Fundamental causes of contagion include macroeconomic shocks that have repercussions on an international scale and local shocks transmitted through trade links, competitive devaluations, and financial links." It can lead to some co-movements in capital flows and asset prices. Common shocks can be similar to the effects of financial links. "A financial crisis in one country can lead to direct financial effects, including reductions in trade credits, foreign direct investment, and other capital flows abroad." Financial links come from financial globalization since countries try to be more economically integrated with global financial markets. Allen and Gale (2000), and Lagunoff and Schreft (2001) analyze financial contagion as a result of linkages among financial intermediaries. The former provide a general equilibrium model to explain a small liquidity preference shock in one region can spread by contagion throughout the economy and the possibility of contagion depends strongly on the completeness of the structure of interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial fragility, through which they explain interrelated portfolios and payment commitments forge financial linkages among agents and thus make two related types of the financial crisis can occur in response.

Trade links is another type of shock that has its similarities to common shocks and financial links. These types of shocks are more focused on its integration causing local impacts. "Any major trading partner of a country in which a financial crisis has induced a sharp current depreciation could experience declining asset prices and large capital outflows or could become the target of a speculative attack as investors anticipate a decline in exports to the crisis country and hence a deterioration in the trade account." Kaminsky and Reinhart (2000) document the evidence that trade links in goods and services and exposure to a common creditor can explain earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed historical pattern of contagion.