4.4.2 Market failure in the financial sector

Question 1

Market failure in the financial sector

Answer 1

The combination of speculation and provision of genuine services means that financial markets are prone to regular crises that cause significant damage to the real economy:
- asymmetric information
- externalities
- moral hazard
- speculation and market bubbles
- market rigging

Question 2

Asymmetric information

Answer 2

The financial sector is that financial institutions often have ​more knowledge compared to their customers​, both consumers and other institutions.
- This means they can sell them products that they do not need, are cheaper elsewhere or are riskier than the buyer realises.
The Global Financial Crisis was partially 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.
Additionally, there can be asymmetric information between ​financial institutions and regulators​.
- The institutions have little incentive to help regulators understand their business and this causes difficulties for the regulators so may allow institutions to undertake harmful activities.

Question 3

Externalities

Answer 3

There are a number of costs placed on firms, individuals and the government that ​the financial market does not pay​.
- Example: 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.

Question 4

Moral harzard

Answer 4

Where individuals ​make decisions in their own best interests knowing there are potential risks​.
1) This can happen in two main ways in the financial markets. 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. ​The Global Financial Crisis was caused by moral hazard, when employees sold mortgages to those who would not be unable to pay them back. By selling more mortgages, they would see higher salaries and bonuses but would not see the negative effects if the loan was not repaid.
2) 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.

Question 5

Speculation and market bubbles

Answer 5

1) Almost all trading in financial markets is speculative and this leads to the ​creation of market bubbles​, where the price of a particular assets rises massively and then falls. 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​.
2) 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.
- Other bubbles included the ​dot com bubble in the 1990s and the Wall Street Crash in 1929.

Question 6

Market rigging

Answer 6

This is 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.
- One example of this is ​insider trading​, where 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 to make a profit.
- Another example is 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. ​
- In the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world.