4.4.2 Market failure in the financial sector Flashcards
What is a systemic risk?
Where the risk that a problem in one part (e.g. a single bank) can lead to the breakdown of a whole market or perhaps even the whole financial system.
- Problems in one country’s financial sector can also quickly spread around the world. What looks like a fairly minor local problem can quickly become a much more serious international situation.
Speculation
Where firms/individuals aim to make a profit by buying assets relatively cheaply and selling them at a higher price
- Speculation always carries some risk (because if asset prices fall, a speculator will lose money)..
Market bubbles
Excessively high estimates of future asset price rises can lead to market bubbles (or ‘asset price bubbles’).
For example:
- Investors expecting the price of an asset to continue to rise can overpay, creating a market bubble (where prices in a market are much greater than the assets’ true worth).
- When investors eventually lose confidence, the bubble will ‘burst’ and investors will rush to sell their assets to avoid large losses. This leads to price plummeting, leaving investors with large debts (if they borrowed the money they invested and worthless assets)
Banks can help to create market bubbles if they give out credit too easily. – Speculators often borrow the money to fund their purchases.
Credit Crunch
Externalities in financial markets
There are negative externalities in financial markets
Some of these come about because of the importance of banks and the financial sector to the wider economy.
Give an examle of an externality in financial markets
Mismanagement of risk is one cause of externalities.
For example, the risks financial institutions took that eventually led to the 2008 financial crisis were ‘paid for’ by the taxpayers – government money was used to prevent the collapse of major banks.
Other negative externalities of the 2008 financial crisis included large drops in GDP, falling salary levels for many workers, and a significant rise in unemployment.
Why do governments ‘bail out’ banks?
Market rigging
When traders on financial markets, or others working in the financial sector, collude to deliberately manipulate markets to make huge profits for themselves and the firms they work for.
- For example, they may make the demand for securities appear higher than it really is to artificially ‘inflate’ their price. This prevents the market from working as it should.
How do governments try to discourage/prevent market rigging?
- There are laws and regulations designed to stop market rigging and punish those that engage in it, but if the penalties aren’t tough enough, or the laws aren’t strict enforced, then they won’t be a deterrent.
- In recent years many banks have been fined billions of pounds by regulators for market rigging. Some of the biggest fines have been as a result of rigging foreign exchange markets as banks collude on the buying and selling of currencies.
Asymmetric information
When one party in a transaction (usually the seller) has less information than the other party (usually the buyer).
For example, borrowers often know better than lenders how likely it is that they’ll be able to repay a loan.
Asymmetric information can lead to adverse selection and moral hazard.
Moral hazard
- Moral hazard occurs when someone is more willing to take risks because they know someone else will have to pay the consequences if anything goes wrong.
- For example, a bank might provide risky loans (to chase higher profits) if it knows that it’ll be bailed out by taxpayers if things go wrong.
Adverse selection
- Adverse selection occurs when the most likely buyers of a product are those that the seller would probably prefer not the sell to).
- Adverse selection leads to a firm unknowingly taking greater risks than it intended.
