10.5 Financial Market Failure Flashcards
What is Financial Market Failure?
When free financial markets fail to allocate financial products and services at the socially optimum level of output resulting in a net loss of social and economic welfare
1. What is speculation in financial markets and how can it lead to market failure?
Excessive Risk 1) Speculation is a common feature of financial market activity. Speculators look to buy financial assets cheap and then sell them on at a higher price sometimes leveraging the transaction (borrowing large sums first to amplify the end outcome of the deal). The issue is when excessively high prices are paid for assets that are clearly overvalued i.e. a market bubble is formed with an overproduction of assets that carry excessive risk of collapsing in price for those who hold them.
Eventually investors realise that the assets are not worth the price and that the market has peaked, reducing demand and lowering the price of such assets. As soon as prices begin to fall, panic sets in and investors in possession of similar assets start to sell to minimise their losses pushing the price down even further. The assets soon become worthless but borrowed money to buy them up needs paying back resulting in damage to the investor but also to banks who lent out money for this purpose increasing the risk of insolvency.
- How does asymmetric information contribute to excessive risk and financial market failure?
Asymmetric information, where one party has more information than the other, can contribute to excessive risk and financial market failure. In the case of banks, knowing that the government or central banks may bail them out in case of failure can create moral hazard. Banks may take on more risk, believing they are “too big to fail,” as they anticipate safety nets will be provided. Despite post-intervention controls and regulations, asymmetric information limits their effectiveness, as banks can conceal risky deals or loans to take advantage of the safety net. This behavior increases systemic risk, risking sector collapse, economic recession, and unemployment, which are not in the interests of society. Asymmetric information can also lead to adverse selection, such as in the insurance industry, where insurers may attract more high-risk individuals, increasing the chances of collapses and excessive risk-taking.
- What are the consequences of bank failure on taxpayers and the economy?
Bank failure can have significant consequences for taxpayers and the economy. When governments perceive a high possibility of systemic risk, they may resort to bank bailouts using taxpayers’ money. This funding can create long-term burdens of debt repayment and debt interest servicing, impacting current and future generations. Additionally, individuals can lose their savings if there is no government savings assurance scheme in place. Bank failures can lead to recessions and high unemployment, not only within the banking sector but also throughout the entire economy. These negative externalities are often ignored by self-interested banks, resulting in the overproduction of excessively risky loans and an increased likelihood of further bank failures.
- How does collusion and price-fixing contribute to financial market failure?
Collusion and price-fixing practices in financial markets can lead to market failure. Market rigging occurs when traders, banks, or intermediaries collude to manipulate markets away from equilibrium levels to generate significant profits. Examples include scandals like LIBOR and FOREX fixing, where fines and regulations were imposed to deter such behavior. Market rigging is against the interests of society as it results in additional charges and unfair outcomes for market participants. Regulation plays a crucial role in curbing such behavior, but it requires strict enforcement and appropriate punishments to be effective in deterring collusion and price-fixing practices.
