Define contagion: Contagion is the situation where there is growing concern about the state of a bank or firms financial affairs. This fear spreads making the initial situation worse due to a collapse in confidence.
For example, if people worry that a bank may be going bankrupt then people will start withdrawing money. As people start to withdraw money, this only increases the risk and fear that the bank will go under. Therefore, more and more people try to withdraw their money as quickly as possible.
Without government intervention or support from the Central Bank, this spiral of contagion can cause the bank to go bankrupt. The financial panic then may spread throughout the banking system.
Great depression and contagion
In the Great Depression, many medium-sized American banks went bankrupt because they were overtaken by nervous investors.
Northern Rock and contagion
In 2007, the UK government were forced to guarantee the Bank Northern Rock, who risked going bankrupt.