4.4 - Market failure in the financial sector Flashcards
Financial sector
Market failure occurs when …
the free market mechanism fails to allocate resources efficiently, leading to sub-optimal outcomes for society.
Market failure in the financial sector
> Asymmetric information
- Asymmetric information occurs when one party in a transaction has more information than the other.
- In the financial sector, this can lead to adverse selection and moral hazard problems.
> Adverse selection: Occurs when individuals with hidden information about their riskiness (e.g., borrowers with poor credit history) are more likely to seek financial products (e.g., loans). This can lead to higher default rates for lenders.
> Moral hazard: Arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information. For example, borrowers may take on excessive risks if they believe they won’t bear the full consequences of their actions.
- Market failure in the
financial sector
> Consideration of:
o asymmetric information
o externalities
o moral hazard
o speculation and market bubbles
o market rigging
- Market failure in financial sector
> externalities
- Externalities are spillover effects that affect parties not directly involved in a transaction.
- In finance, externalities can result from risky behaviours of financial institutions.
> Negative externalities: Financial institutions may engage in risky practices (e.g., excessive lending) that can lead to systemic risks affecting the entire economy. The 2008 financial crisis is an example of negative externalities.
There are a number of costs placed on firms, individuals and the government that the
financial market does not pay . One example of this is the cost to the taxpayer of bailing out the banks after the 2007-8 financial crisis . Even higher than this, was the long-term cost to the economy of the crisis due to its effects on demand and growth. Moral hazard also
shows some external costs.
- Massive negative externalities - ‘run on banks’, interdependence, confidence/animal spirits = potential for contagiom
- Massive externalities leads to government intervention - bail outs
> Bail outs create moral hazard - incentive to take more risk - self fulfilling
> Positive externalities: A well-functioning financial sector can benefit the broader economy by efficiently allocating capital and promoting economic growth.
Market failure in the financial sector
- Moral hazard
- Moral hazard refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their actions.
- In the financial sector, moral hazard can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis.
- This can lead to reckless behaviour and excessive risk-taking.
2 ways moral hazard can occur
- Firstly, it will
occur where individual workers take adverse risk in order to increase their salary . Any problems they cause will be the problem of the company and not the problem of the
individual, the worst that can happen is to lose their job whilst the company may lose millions
of pounds. - On top of this, financial institutions may take excessive risk because
they know the central bank is the lender of last resort and so will not allow them to fail
because of the impact it would have on the economy.
Example of when moral hazard occurred
- The Global Financial Crisis was caused by moral hazard, when employees sold
mortgages to those who would not be unable to pay them back.
= sub-prime mortgages - By selling more mortgages, they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid
Market failure in the financial sector
- Speculation and Market Bubbles
- Speculation involves buying assets (e.g., stocks or real estate) with the expectation of profiting from price increases, rather than from the asset’s intrinsic value.
- Market bubbles occur when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance.
- Bubbles often burst, leading to market crashes and financial instability.
How might market bubbles form?
- They tend to
occur because investors see the price of an asset is rising and so decide to purchase this
asset as they believe the price will continue to rise and will profit them in the future. - This leads to prices becoming excessively high and eventually enough investors decide that the
price will fall, so they sell their assets and panic sets in, causing mass selling. - This is known
as herding behaviour. - Moreover, the financial market has also caused market bubbles in
the housing market by lending too much in mortgages and increasing demand for houses. - When this bubble bursts, for example due to a rise in real interest rates, there is a fall in demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full.
Market failure in the financial sector
- Market Rigging
- Market rigging refers to the manipulation of financial markets to gain unfair advantages.
> Examples include insider trading (trading based on non-public, material information), market manipulation (e.g., pump-and-dump schemes), and collusion among market participants to distort prices.
- Market rigging undermines market integrity and can lead to investor losses.
> a group of individuals or institutions collude to fix prices or exchange
information that will lead to gains for themselves at the expense of other participants in
the market.
Insider trading
- Trading based on non-public, material information
> An individual or institution has
knowledge about something that will happen in the future that others do not know and so can buy or sell shares/assets to make a profit.
How might individuals or institutions affect prices to rig the market?
- Where individuals or
institutions affect the price of a commodity, currency or asset to benefit themselves, for
example large trades in a currency will shift its value and this will make a difference to
individuals selling or buying assets with that currency.
Example of market failure in financial market
Credit crunch & Great recession (2008-2011)
How can a financial system be rescued
Bank bailouts
Bank bailouts
> Uk and Us approach
- Uk approach
> Bank capitalisation
> government pumped money in and took a stake in the banks: effectively part-nationalisation - Us approach
> The TARP - the troubled asset relief programme
> the US government bought all the worthless mortgage backed securities off the banks - removed bad assets from them - Quantitative easing
> Central Banks bought Government bonds in the secondary market. Mainly buying them from banks and insurance companies - so this directly injected cash into the system.
Government policies did two main things for the financial sector
> Central Banks did the same again in March 2020 to prevent the Covid lockdowns causing a massive financial crisis.
> and during great recession
- Injecting liquidity
> ability to buy and sell (trade) easily and reliably. This means banks can meet their obligations (pay their debts) daily. Provides confidence - An injection of capital
> the long-term funding a bank needs in order to be stable and secure and to fund its own borrowing (leverage) and lending to others.
Government interventions create greater Moral Hazard as They will encourage banks to take even greater risks in the future
What is the solution to this problem (long-term Bank regulation):
- Macro-prudential
- Micro-prudential
Macro-prudential
regulating the system as a whole - preventing systemic risks from building up. Stopping panics from happening, preventing excessive risk.
Micro-prudential:
regulating individual firms and improving their behaviour / ensuring they are safe for their customers.
Macro-prudential regulation includes:
- The FPC: The Financial Policy Committee of the Bank of England.
- Annual Financial Stability Report.
- Stress-testing the Banks - can they cope with different economic and financial scenarios? What would happen if…?
> Do they have enough Capital (known as Capital adequacy)
> Do they have enough Liquidity (can they get hold of cash quickly)
What happens if the FPC thinks risks in bank are growing
If the FPC thinks risks are growing it can require banks to hold more capital. This means they must raise more money, keep more assets on their books and reduce their leverage (borrowing). This reduces bank’s profitability but makes the system more resilient.
The central bank measures Capital and liquidity Ratios
- The Central Bank measures the Capital Ratios of the banks
> how much capital do they have in reserve against their riskier investments. This is the measure of how much risk they are taking. - The FPC can also demand that the banks hold more liquidity (cash and government bonds)
> so that they can pay their depositors back if there’s a sudden ‘run on the bank’. These are Liquidity ratios.
liquidity
refers to how easily assets can be converted into cash without affecting their value
what does liquidity refer to in context of banks?
refers to the banks ability to meet short-term obligations (like paying out withdrawals or fulfilling other financial commitments) without needing to sell off assets at a loss
