4.4.2 - Market Failure in the financial sector Flashcards
Name five types of market failure in financial sector
. Asymmetric information
. Externalities
. Moral Hazard
. Speculation and market bubbles
. Market rigging
Explain asymmetric information
. Asymmetric information is when when one party in a transaction has more information than another party, and uses that advantage to exploit the other party.
. Financial institutions have more knowledge than their customers and other financial institutions and regulators
. This means they can sell them products they don’t need, are cheaper elsewhere or riskier than the buyer realises
E.g. Mortgage sellers often understand the implications of interest rate changes to repayments much better than the average consumer.
E.g. 2008 GFC showed that mortgage brokers have greater knowledge than consumer as they sold subprime mortgages without informing them of the risks associated.
Define Market Failure
when the market fails to allocate scarce resources to the socially optimum level
Explain Moral Hazard
. Occurs when an economic agent makes decisions in their own interest knowing that there are potential risks, which will be partly borne by other economic agents
E.g. The GFC was caused by when employees took a short - term risk and sold subprime
mortgages to those who would not be unable to pay them back in order to increase their salary
E.g. 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
E.g. Banks may engage in highly profitable, high - risk activities because they know if they make large losses, the central bank will bail them
Explain Speculation and market bubbles
Most trading in financial markets is speculative, which lead to the creation of market bubbles. They tend to occur because investors see the price of an asset is rising and so decide to purchase this asset (herding behaviour) 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 realise their profit and sell causing prices to fall. This causes panic to sets in, causing mass selling. This is known as herding behaviour.
Herding behaviour exists because investors base their actions of what other investors are doing, instead of underlying value of an asset
E.g. In the UK, financial markets created bubbles in the housing market. By lending too much into the property market, financial institutions have created too much demand for housing.
Then something happens to burst the bubble, such as increased interest rates, which increases mortgage repayments and increases number of houses defaulting on their debts. It also reduces demand for new mortgages, which leads to fall in house prices. The fall in house prices leads to negative equity as indebted households own more than their own mortgage than the new lower value of the house they bought.
Banks are left with loans that are not going to be repaid, which results in less credit to loan out firms and consumers The collapse in house prices also leads to a fall in real spending. Household wealth has also fallen due to increase mortgage payments, which reduces consumer confidence
Unemployment increase in housing related services such as real estate agents
Define Speculative trading
conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain.
Explain Market Rigging
. Where 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
An example of market rigging is INSIDER TRADING Where an individual or institution has knowledge about something that will happen in the future that other don’t know and so they can buy or sell shares to make a profit.
E.g. An individual may know that in 24 hours time two firms will announce a merger that will push up share prices. He or she buys shares in the company before the merger and sells that for a profit later.
Explain negative externality
A negative externality is when consuming or producing a goods results in a cost to a third party.
There are a number of costs placed on firms, individuals and the government that the
financial market does not pay
Example : cost to the taxpayer of bailing out the banks after the 2008 financial crisis
