4.4.2 - Market failure in the financial sector Flashcards
Causes of Market failure in the
financial sector
o asymmetric information
o externalities
o moral hazard
o speculation and market bubbles
o market rigging
Define asset bubble
A sustained rise in the prices of assets such as housing and equities which
takes their values well above long run sustainable levels.
Define financial crisis
A disturbance to financial markets, associated typically with falling asset
prices and insolvency amongst debtors and intermediaries, which ramifies
through the financial system, disrupting the market’s capacity to allocate
capita
Define insolvency crisis
An agent (such as business, individual or a bank) is insolvent when its debt
relative to its income is so high that it will not be able to pay back its debt
and the interest on it (i.e. there is an unsustainable debt). An insolvency
crisis may require some form of debt restructuring / debt relief to lower
default risk
Define liquidity trap
A liquidity trap occurs when low interest rates and a high amount of cash
balances in the economy fail to stimulate aggregate demand partly through
a lack of confidence.
Define systemic risk
The possibility that an event at the micro level of an individual bank / insurance company could then trigger instability or the collapse an entire industry or economy.
Define subprime lending
sub-prime lending is lending money, usually to buy a house, to people who
are risky to lend to. To compensate for this risk, commercial banks charge
higher interest rates
Define moral hazard
Moral hazard exists in a market where an individual or organisation takes
many more risks than they should do because they know that they are either
covered by insurance, or that the government will protect them from any
damage incurred as a result of those risks
Define market rigging
llegally and unfairly controlling the price or the interest rate in order to increase their joint profits or exploit consumers
Booklet definition of market rigging
Market rigging or market manipulation is a type of market abuse in which there is deliberate attempt to interfere with market forces. It can be seen as market failure as it leads to a less efficient allocation of resources and undermines trust in the financial system.
Explain the concept of a bubble
- The term “bubble,” in a financial context, generally refers to a situation where the price of an asset exceeds its fundamental value by a large margin.
- Because speculative demand,
rather than intrinsic worth, fuels the inflated prices, the bubble - eventually but inevitably pops, and massive sell-offs cause prices to decline, often quite dramatically.
- Bubbles result in a misallocation of financial capita
Define speculation
Speculation is the activity of buying a good or service in anticipation of a
change in the price/market value e.g. currency or stock-market speculation
Examples of market rigging
- make demand for securities appear higher than it is to artificially inflate its price
assymetric info in financial markets
- financial institutions have more
knowledge compared to their customers , both consumers and other institutions. - they can sell them products that they do not need, are cheaper elsewhere or are
riskier than the buyer realises. - GFC was caused by banks
selling packages of prime and subprime mortgages, but advertising them as all prime mortgages. - Those buying these packages suffered from asymmetric information and it is
unlikely they would have bought them if they knew the risk involved.
describe presence of externalities in the financial market
- 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 bailingout 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
