4.4.2 Market Failure in the Financial Sector Flashcards
What is financial market failure
Where free financial markets fail to allocate financial products at a socially optimum level of output
What is the main reason for financial market failure
What are the consequences of this
excessive risk
Consequences: Systemic risk: due to loss of confidence in banking systems
Financial crisis leading to recession, losses in income/jobs/output
Bank bailout (like 2008) and likely moral hazard in the future
What do some people say has increased the chance for market failure and systemic risk in the financial market
What did it involve
Deregulation of financial markets in UK + US between 1960s + 1980s
It involved: removing capital + liquidity rations, scrapping reserve requirements, using commercial bank funds for investment banking activities
Suggest how speculative bubbles has led to market failure in the financial market
a speculative bubble is a sharp & steep rise in asset prices such as shares, bonds, housing, commodities or crypto-currencies
The bubble is usually fuelled by high levels of speculative demand which takes prices well above fundamental values
What can cause speculative bubbles
- herd behaviour of investors
- exaggerated expectations of future price rises
- period of low interest rates - encouraging risky investment
How can asymmetric information lead to market failure in the financial market
This type of market failure exists when one individual or party has much more information than another individual or party and then uses that advantage to exploit the other party.
often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.
How can externalities in the financial market lead to
What is the contagion effect
an externality exists when a market transaction has a positive/negative consequence for a 3rd party
can lead to the contagion effect, through lack of trust and confidence between savers and financial institutions
contagion is the spread of an economic crisis from one market or region to another
What is systemic risk
When one or more financial organisations experience problems, this can lead to the risk of a much wider damage to the economy and perhaps threaten the stability of much of the financial system.
Millions of people can be affected negatively as a result
Give some examples of negative externalities from the 2008 financial crash
Depositors (Risk of lost savings if a bank collapses)
Creditors (A rise in unpaid debts can create difficulties)
Shareholders (Lost equity from falling share prices)
Why might moral hazard cause market failure in the financial market
Moral hazard exists where an individual or organisation takes more risks because they know that they are covered by insurance, or they expect that the government will protect them (i.e. bail them out) from any damage incurred as a result of those risks
examples of this in finance: Government bail-outs of commercial and investment banks encourage them to engage in riskier behaviour
Sub-prime mortgage lenders prior to 2007 were able to repackage loans into bundles bought by other institutions
How can market rigging cause market failure in the financial market
Collusion or abuse of the power resulting from operating in a concentrated market. Market rigging happens when some of the companies in a market act together to stop a market working as it should in order to gain an unfair advantage
When there is a small number of firms in a market, they may choose to work together to increase their joint profits and exploit consumers
harms consumers by inhibiting competition
This can be done through collusion and fixing interest rates/exchange rates - leading to monopoly power
What type of market is the financial market reckoned to be
The UK banking sector for example is dominated by a few very large banks, including the Lloyds Group, Barclays, the Royal Bank of Scotland (RBS), and HSBC
It is oligopolistic - there are significant barriers to entry into the market which make life hard for new entrants as they seek to establish themselves and make a profit.
