4.4.2 Market failure in the financial sector

Question 1

How does market failure occur in the Financial market?

Answer 1

The combination of speculaton and provision of genuine services means that financial markets are prone to regular crises that can significantly damage the real economy.

Question 2

How does Asymmetric infomation cause market failure in the financial market?

Answer 2

• Asymmetric Infomation- Insitutions often have more knowledge than their customers like Banks selling Sub Prime mortages but listing them as prime to buyers (partly caused the global financial crisis).
• Also, financial instiutions are unlikely to provide relevant infomation to regulators making it hard for them to understand businesses and how to regulate them. This can allow instituions to undertake harmful activities.

Question 3

How do externalities cause market failure in the financial market?

Answer 3

• Externalities - There are a number of costs placed on firms, individuals and the government that the financial market does NOT pay. For instance, the cost to the tax payer bailing out the banks after the 2008 financial crisis.

Question 4

How does Moral Hazard create market failure in the financial market?

Answer 4

Individuals or institutions make decisions in their own best interests knowing there are potential risks that they often do not have to pay for.

• Workers taking on adverse risk in order to increase their salary - any problem arising is at the detriment of the company not them themselves. For instance, bank lenders sold mortages to people who they knew couldn’t lend them back - boosting their own salary but costing the banks millions.
• On top of this, financial instituions may take excessive risk as they know the centeral bank is the lender of last resort and will not allow them to fail beacuse of the impact it would have on the economy.

Question 5

What is speculation and market bubbles and how does it cause market failure in the financial market?

Answer 5

Almost all of trading in financial markets is speculative leading to the creation of market bubbles where the price of a particular asset rises massively and then falls.

• It originates from “Herd Behaviour” where individuals all buy a stock because they see growth in it. Then when demand becomes too high and prices are peaking they start to sell as they decide price will fall - this leads to panic selling and the stock to crash.
• Banks can also cause market bubbles by lending too many mortages and then when the bubble bursts due to rising interest rates there is a fall in demand for houses and AD drops.

Question 6

What is Market Rigging?

Answer 6

Market rigging refers to the illegal practice of manipulating financial markets for personal gain. It can take various forms, such as insider trading, price manipulation, and collusion among market participants. Market rigging can occur in any financial market, including stocks, bonds, commodities, and currencies

• This leads to market failure by distorting prices and undermining trust, which reduces market efficiency, harms fair competition, and can lead to resource misallocation.