4.4.2 Market Failure in the Financial Sector

Question 1

What are examples of financial market failure?

Answer 1

Question 2

What is market failure?

Answer 2

Market failure occurs when a market fails to deliver an economically efficiency and/or socially equitable allocation of
scarce resources. Market failure is a justification for government intervention e.g. through financial regulation although
this too might lead to governmental / regulatory failures as a result

Question 3

What is asymmetric information?

Answer 3

• 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.

Question 4

How does asymmetric info apply to financial markets?

Answer 4

• Finance is a market in information – 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.

Question 5

What is negative externality?

Answer 5

• A negative externality exists when a market transaction has a negative consequence for a 3rd party.

Question 6

What is positive externality?

Answer 6

• A positive externality exists when a market transaction has a positive consequence for a 3rd party.

Question 7

How might there be externalities in the financial sector? Refer to systemic risk.

Answer 7

Externalities in financial markets seem large – especially contagion effects – for example when there is a loss of trust and confidence between lenders and also between savers and financial institutions such as banks. A key concept is systemic risk – which means that, 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.

Question 8

What does the BoE think about the effects of the Global Financial Crisis and recession?

Answer 8

The Bank of England estimates find that the Global Financial Crisis and recession that followed it left everyone in the
UK around £20,000 worse off than had the crisis not materialized. In part this is the result of lower real income, output
and employment across many sectors of the economy. It also comes from the fiscal costs of the bail-out of banks
during the Global Financial Crisis and ensuing period of fiscal austerity.

Question 9

Examples of external costs (negative externalities) arising from financial crises:

Answer 9

1. Taxpayers (taxpayers bear the cost of bank bail-out costs and the impact of fiscal austerity)
2. Depositors (Risk of lost savings if a bank collapses)
3. Creditors (A rise in unpaid debts can create difficulties)
4. Shareholders (Lost equity from falling share prices)
5. Employees (Lost jobs in finance & the wider economy especially if a financial crisis turns into a recession)
6. Government (increased fiscal deficit and national debt)
7. Businesses (reduced demand for goods and services and higher borrowing costs for those needing loans)

Question 10

What is moral hazard?

Answer 10

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.

Question 11

What are examples of moral hazard?

Answer 11

• Individuals with large insurance policies to cover specific risks are more likely to claim against such policies.
• Government bail-outs of commercial and investment banks encourages them to engage in riskier behaviour
• Sub-prime mortgage lenders prior to 2007 were able to repackage loans into bundles bought by other
  institutions

Question 12

What is a speculative bubble?

Answer 12

• 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

Question 13

What are examples of speculative bubbles?

Answer 13

Question 14

What factors can cause a speculative bubble?

Answer 14

• Behavioural factors e.g. the herd behaviour of investors
• Exaggerated expectations of future price rises (i.e. people expect property prices to carry on increasing)
• Irrational exuberance of investors – a term coined by Nobel-winning economist Robert Shiller
• A period of very low monetary policy interest rates – which encourages risky investment by people and by
  other agents in financial markets in search of higher yields

Question 15

What is market rigging?

Answer 15

• This market failure is effectively 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.

Question 16

Why is price rigging illegal?

Answer 16

• Price rigging is illegal because it interferes with the natural market forces of supply and demand and harms
  consumers by inhibiting competition

Question 17

Explain how there may be monopoly power in the financial system

Answer 17

Market failure can arise when a market is not sufficiently competitive. 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. In term
of market shares for all categories of business, the market is clearly 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

Question 18

Examples of barriers to entry into commercial banking

Answer 18

1. Regulatory barriers – i.e. the need to be given a banking licence by the central bank
2. Natural or intrinsic barriers to entry – costs of entering the market including marketing costs, building IT and
   payments infrastructure
3. Strategic advantages of larger banks – including vertical integration, branch network, low rates of customer
   switching
4. First mover advantages including strong brand loyalty for established banks

Question 19

Brand loyalty leads to low rates of consumer switching. Why?

Answer 19

This ties in with behavioural theories since the default choice of which bank to use is powerful in this market – leading to low rates of customer switching to other current accounts.

Question 20

What is systemic risk?

Answer 20

Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could
then trigger instability or collapse an industry or economy.

Question 21

The Global Financial Crisis (GFC) illustrated how deeply inter-connected the financial world has become. Explain why.

Answer 21

• Shocks in one location (e.g. the USA) or one asset class (e.g. sub-prime mortgages) can have a sizable impact
  on the stability of institutions and markets around the world.
• Since the crisis, financial regulators have tried to make the banking system less vulnerable to economic shocks
  and create firewalls to prevent damage from systemic risk