4.4.2: Market Failure In The Financial Sector

Question 1

What are the different types of market failure in the financial sector?

Answer 1

• Asymmetric Information
• Externalities
• Moral Hazard
• Speculation and Market Bubbles
• Market Rigging

Question 2

How is asymmetric information caused in the financial sector?

Answer 2

• Financial institutions often have
  more knowledge compared to their customers.
• 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.
• There can be asymmetric information between financial institutions and regulators
• as 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

How are externalities caused in the financial sector?

Answer 3

• There are costs placed on firms, individuals and the government that financial markets don’t pay for.
• EXAMPLE, the cost to the taxpayer of bailing out banks after the 2007-8 financial crisis, and the long term cost to the economy on AD and growth.

Question 4

What is moral hazard?

Answer 4

• Where individuals make decisions in their own best interests knowing there are potential risks

Question 5

What are the two main ways that moral hazard happen in financial markets?

Answer 5

• 1. Where individual workers take adverse risk in order to increase their salary
• EXAMPLE: The Global Financial Crisis was caused by moral hazard, when employees sold mortgages to those who would not be able 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. Where financial institutions may take excessive risk because they know the central bank is the lender of last resort; so they will not allow them to fail because of the impact it would have on the economy.

Question 6

How are speculation and market bubbles caused in the financial sector?

Answer 6

• Trading in financial markets are speculative, leading to the creation of market bubbles.
• Due to market bubbles, prices of assets become excessively high and eventually enough investors decide that the price will fall, so their assets and panic sets in, causing mass selling; herding behaviour
• EXAMPLE, market bubbles in the housing market by lending too much in mortgages and increasing demand for houses, when bubble bursts, negative wealth effect occurs

Question 7

What are market bubbles?

Answer 7

• Where the price of a particular assets rises massively due to speculative demand and then falls sharply.

Question 8

What is market rigging?

Answer 8

• Where a group of individuals or institutions collude to fix prices , manipulate the functioning of financial markets or exchange information to achieve a desired outcome, for personal gain

Question 9

What is an example of market rigging?

Answer 9

• Insider Trading; 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 profit

Question 10

What is a real life example of market rigging in the financial sector?

Answer 10

• In the Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR)