4.4.2 - Market failure in the financial sector Flashcards
How did the 2008 financial crash begin ?
Then after Wall Street banks were hearing how well the layman brothers were doing they also started selling more subprime momrtgaes causing an increase in the demand for house prices to rise further .
- Howvere the bubble burst as homeowners started selling their houses since their house prices increased, increasing the supply of houses causing house prices to decrease.
what is a subprime mortgage ?
A mortgage that the borrower is unlikely to be able to pay back
Different types of financial market failure
What is asymmetric information in financial markets ?
When one party know more information than another in a transaction.
- E.g in the 2008 financial crisis where the bankers knew more about the risky subprime mortgage than the people they were lending to. (The adjustable rates).
What do you understand about speculation and market bubbles In financial markets ?
- Speculation in financial markets usually leads to the creation of market bubbles. ( Where the price of particular assets rise drastically and then plummets).
- They tend to occur because investors speculate that a price of an asset will ⬆️ = people start purchasing these assets as they think they can make a profit from these in the future. This creates a ____bubble ➡️ Prices become excessively high and investors decide that price will fall so they sell their assets causing **mass selling*. This is known as as herding behaviour.
What is herd behaviour and how does it manifest itself in financial markets ?
individuals make decisions based on the actions of others, rather than on their own independent analysis.
Why does herd behaviour exist ?
What is meant by negative externalities in the financial sector ?
- The US government had to use £700bn of tax payers money to bail out banks when they could have used it to improve healthcare in the US (huge opportunity cost)
- Buisness and individuals couldn’t get loans even though they weren’t directly involved with the crash. So some business even had to cut back on business projects. Which as a result meant that many people became unemployed.
What is meant by moral hazards in financial markets.
- This occurs when financial institutions make continually make risky decisions and act in their own best interest as they believe that will be protected from the full consequences of their actions.
- E.g Government having to step in to bail banks out after they were lending out risky subprime mortgages in the 2008 financial crisis. This was to prevent further unemployment and decrease in Real GDP.
What is meant by market rigging in financial markets.
- The illegal practice of manipulating financial markets/ rigging key interest rates or exchange rates in order to profit maximise.
- Example :
LIBOR : Where Barclays manipulated LIBOR to gain profits. They had to pay a £450m fine.
What is LIBOR and why is it important ?
A global benchmark interest rate used to set a range of financial deals.
- As well as helping to decide the price of other transactions, it is also used as a measure of trust in the financial system and reflects the confidence banks have in each other’s financial health.
When a market bubble burst what happens to the economy ?
- Price of houses decrease (value decrease) but remortgage payments stay the same - Negative wealth effect and so animal spirits, so consumption decreases.
- They also can’t repay their mortgages so banks face a huge loss.
- So lending by firms decrease, and so investment may decrease further.
- Also government have to bailout banks using tax payers money so taxes may increase (negative externalities). Also can’t use tax for gov expenditure in healthcare (opportunity cost).
- Also people who saved in banks also loose their savings (further neg externalities).
