when the shock causes a contraction of credit or when the shock is associated with significant loss of financial wealth of households and companies.

_Systemic risk_ usually refers to financial shocks that are likely to be serious enough to damage the real economy. As an illustration, the Group of Ten (2001) defines systemic risk as the risk that an event (shock) will trigger a loss of economic value or confidence in—and attendant increases in uncertainty about— a substantial portion of the financial system that is large enough to have significant adverse effects on the real economy, in all probability. _Contagion_ is at the very core of systemic risk. It refers to the mechanisms through which shocks propagate from one element of the financial system to another and from the financial system to the real economy.

A distinction should be made between real and information contagion channels. Contagion through the _real channel_ refers to the direct “knock-on effects” on other parts of the financial system through direct exposures (such as counterparty exposures) and interconnections (such as through payment systems). As financial systems become more sophisticated, the degree of interconnectedness generally increases significantly.

In addition to contagion through direct exposures, contagion may spread through the _information channel_ . Contagion through the information channel occurs when economic agents (including counterparties, investors, and depositors) change their behavior in response to a particular event. While the intensity and direction of contagion effects as a result of direct exposures and interconnections can in principle be assessed beforehand, contagion through the information channel is much more difficult to predict.<sup>3</sup> Following the announcement of serious difficulties at a particular bank, investors may start speculating which other banks are susceptible to the originating shock, due to similarities in business models (such as weak internal controls), financial exposures (such as toxic assets), and so on The institutions that are affected in the second round are likely to be confronted with a deterioration of their financial outlook, which may manifest itself in the form of downgrades, rising risk premia and costs of capital, and greater difficulties in attracting finance.

In this way, a crisis in a market may trigger changes in the interpretation given to existing information. Financial markets, however, are not always “right” in the way that information is reassessed. Such “unjustified” information reassessment can materialize in various forms: herd behavior (when diverse investment categories are bucketed together in the same high risk category), informational cascades (situations in which every agent chooses the same action, regardless of his own private information), or sudden reappraisals of economic fundamentals (so-called sunspots; see Vaugirard 2007).

> 3 More sophisticated methodologies are currently being advanced, including network analysis and portfolio models of risk based on market data, aimed at better capturing contagion through the information channel (see IMF, BIS, FSB 2009). Network analysis entails the construction of a matrix of gross institutional exposures, while analyzing the specific characteristics of the network structure (distribution of nodes, intensity and complexity of connections, and so on). Portfolio models are aimed at identifying common risk factors, tracking how distress in one institution may affect others and measuring the contributions of individual institutions to system-wide risk. The availability of data with total exposures, on a consolidated basis, is often problematic, in practice.

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