Explain the concept of credit contagion and how it can impact a bank's lending portfolio during a financial crisis.

Credit contagion, also known as credit risk contagion, is a phenomenon where the failure of one borrower or financial institution can trigger a domino effect of defaults and financial distress among other borrowers and institutions. This occurs due to interconnectedness in the financial system, where borrowers and lenders are linked through various financial instruments like loans, bonds, derivatives, and other forms of credit.

Here's how credit contagion can impact a bank's lending portfolio during a financial crisis:

1. Interbank lending: Banks lend to each other in the interbank market. If one bank fails, it can trigger a chain reaction as other banks who lent to the failed bank face losses, leading to liquidity shortages and further defaults. This can force banks to cut back on lending, even to healthy borrowers, leading to a credit crunch.

2. Collateralized debt obligations (CDOs): These complex financial instruments bundle together various loans, often including mortgages. When the value of the underlying loans deteriorates, as in a housing market collapse, CDOs can lose value. This can affect banks holding CDOs, leading to losses and reducing their lending capacity.

3. Counterparty risk: Banks engage in derivative contracts with other financial institutions. If a counterparty defaults, the bank holding the contract faces losses. This can lead to a ripple effect, as other banks holding similar contracts with the defaulted institution also face losses, impacting their ability to lend.

4. Confidence loss: A major financial crisis can erode confidence in the financial system. Borrowers may become hesitant to take on new debt, while lenders become more cautious about extending credit. This can lead to a decrease in lending activity, hurting the overall economy and further impacting banks' loan portfolios.

Examples:

The 2008 Financial Crisis: The collapse of Lehman Brothers, a major investment bank, triggered a credit contagion. This caused widespread losses among other banks, as they held CDOs and other instruments linked to Lehman. The resulting credit crunch led to a severe recession.
The Global Financial Crisis of 1997-98: The Asian financial crisis started with the devaluation of the Thai baht. This triggered a domino effect of currency devaluations and financial instability in other Asian countries, leading to a credit crisis and bank failures.

Credit contagion can have significant consequences for banks, leading to losses, liquidity shortages, and a reduction in lending capacity. This can further contribute to economic downturns and exacerbate financial crises. Understanding and mitigating credit contagion risk is crucial for financial institutions to maintain stability and resilience in the face of economic shocks.