4.4.2 PART 2

Question 1

Why might assymetric information cause financial market failure

Answer 1

• Many financial products are complex & difficult for consumers to understand
• sellers have significant information advantage over buyers

Question 2

Example of assymetric information in 2008 global financial crisis

Answer 2

• E.g. During the financial crisis, financial institutions bundled thousands of mortgages together & sold them on to investors. The sellers had more information on the risk profile of each bundle than the buyers
• E.g. Mortgage sellers often understand the implications of interest rate changes to repayments much better than the average consumer

Question 3

What did GFC show

Answer 3

asymmetric information even exists between financial markets & the regulators set up to monitor them

Question 4

Explain the negative consumption externality in financial markets

Answer 4

E.g. When investors speculate on property prices, a negative consumption externality occurs as young buyers end up paying more (or being forced out of the market) due to the higher prices caused by speculation (AirBnB effect)

Question 5

Another negative externality in financial markets

Answer 5

When banks in many developed nations relaxed mortgage lending requirements this helped cause the Global Financial Crisis. The impact of the crash reverberated around the world causing a global depression which reduced or eliminated imports from many developing countries (third parties to the global mortgage market

Question 6

Describe market bubbles

Answer 6

• The higher the money supply in an economy, the greater the speculation & potential for market bubbles
• Significant amounts of quantitative easing since 2008 have increased the money supply & created potential bubbles in different markets (e.g. property, cryptocurrency, shares)

Question 7

Describe moral hazard

Answer 7

• Moral Hazard has increased in the financial sector since 2008 as Governments have stepped in to save individual banks from failure (e.g. RBS)
• Banks seem to be considered ‘too big to fail’ & governments bear the consequences of their risky behaviour
• The financial sector returned to questionable practices within two years: The China Hustle documents how investment funds & stockbrokers played up obscure Chinese companies who presented fake financial data. This stimulated investor demand, temporarily pushing up prices. Many investors lost a lot of money

Question 8

Why did moral hazard occur in the financial market

Answer 8

• The Global Financial Crisis was caused by moral hazard, when employees soldmortgages to those who would not be unable 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 (at msot lose job whilst company loses millions) .
• On top of this, financial institutions may take excessive risk because
  they know the central bank is the lender of last resort and so will not allow them to fail because of the impact it would have on the economy.

Question 9

Examples of market bubbles

Answer 9

• When this bubble bursts, for example due to a rise in real interest rates, there is a fall in demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full.
  -Other bubbles included the dot com bubble in the 1990s and the Wall Street Crash in 1929.

Question 10

Example of market rigging

Answer 10

• insider trading, where 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 a profit.
• or, individuals or
  institutions affect the price of a commodity, currency or asset to benefit themselves, for
  example large trades in a currency will shift its value and this will make a difference to
  individuals selling or buying assets with that currency
• In the Libor scandal of 2008, financial
  institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the
  most important rates in the world.

Question 11

Role of central bank as bank to other banks

Answer 11

-if banks experience liquidity problems, they can turn to the central banks to sell their illiquid assets or to take a loan in the short term.
- If the bank is on verge of collapse as assets have fallen too far in value e.g. the financial crisis of 2007-8, bank can lend them money to prevent them from collapsing. Banks tend to lend to each other and so the collapse of one bank will lead to the collapse of other
banks; this means that this role is important since as it allows the bank to ensure
financial stability.

Question 12

How does the bank act as lender of last resort

Answer 12

• liquidity assurance scheme where BOE offers non emergency liquidity (just periodic to keep banks going) or emergency liquidity which is needed in large amoutns right now
• CB does it if they feel there is large central banks
• but won’t intervene if bank goes insolvent bc of poor decisions, but banks will let them fail safely so customers not saved
• interest must be paid on these liquidity payments but interest and regulation is even higher for emergency liquidity

Question 13

What are the most important bank role

Answer 13

• lender of last resort
• regulator of financial system
  WHY = financia stability - this is crucial for confidence in the financial system to stay high thus,
• prevent panic and run on the bank
• reduce financial instability and systemic risk
• ## adivse gov of bank bailouts

Question 14

Evaluate the lender of last resort role of a bank

Answer 14

1) moral hazard -liquidity assurance scheme by central bank promotes this
2) banks may not hold sufficient - they know central bank will provide liquidity in any situation so banks will take greater risks and lend out longer term assets which are more profitable and if short term liabilities/interest needs to be fulfilled, go to CB
3) Regulatory capture - regulators are influenced by associates working in the industry and work in the firm’s favour rather than society
4) Why should banks be able to be bailed out but not other firms - they should go bankrupt if they fail. £75 000 savings are backed by the government for each person if a bank fails

Question 15

Explain excessive risk as a cause of financial market failure

Answer 15

• excessive risk happens when there is overproduct of financial assets leading to
  1. systemic risk
  2. recession, lost incomes, jobs, financial crisis
  3. bank bailouts -negative externaloty

Question 16

What is market rigging

Answer 16

essentially collsuion and fixing of interest rates/exchange rates - monopoly pricing

Question 17

What exacerbated financial market failure

Answer 17

• Deregulation of financial markets under marg thatcher and USA
• why increased failreu and sys risk
  1) taking away capital and liquidity ratios
  2) scrapping revenue requirements
  3) using commercial bank funds for investment bank activites as diff types of bank no longer have to be seperate entities. Ib activity is so risky and can drag down the commercial bank

Question 18

What is a leveraged deal

Answer 18

Where you borrow to amplify the end outcome of a deal (borrow large amount, agree to repay it with interest, buy a lucrative asset, sell it for a higher price, pay back loan costs and make massive profit exceeding what you began with)

Question 19

Risk of leverage deals

Answer 19

• doing this deals over and over again bc people think prices will rise forever creates a market bubble with superficial price estimates but sudden fall in demand reduces prices and now people sit on depreciating assets that wont sell enough to pay back loans. Selling assets means price falls further

Question 20

Negative externality

Answer 20

• cost to tax oayer of bailouts due to banks being too big to fail
• loss of savings
• lost jobs, savings, growth

Question 21

Outline the libor scandal

Answer 21

• The LIBOR is a benchmark interest rate that is used to set the cost of borrowing for a wide range of financial products, including mortgages, credit cards, and student loans.
• -The LIBOR is a benchmark interest rate that is used for the pricing of loans and derivative products throughout the world. It is formed using reference interest rates submitted by participating banks. During the LIBOR Scandal, traders at many of these banks deliberately submitted artificially low or high interest rates in order to force the LIBOR higher or lower, in an effort to support their own institutions’ derivative and trading activities
• Evidence emerged that some of the banks were artificially lowering or raising the LIBOR to benefit their own financial positions, such as by making their own borrowing costs appear lower than they actually were and profit from trades - affected cost of borrowing for millions/misdpriced financial assets
• resulted in major fines for banks, increase attention from financial regulators to improve integrity of benchmark interest rates and transparency

Question 22

Evidence of monopoly power as a cause of market failure in financial markets

Answer 22

• UK payment systems industry dominated by a small no of firms, the largest 3 - Mastercard, Visa, and BACS - accounting for over 95% of transactions by value in 2020, according to the Payment Systems Regulator, concentration of market power cause concerns of high fees and limited comp
• market conc in IB: Goldman Sachs, JPMorgan Chase, Morgan Stanley, Bank of America Merrill Lynch, and Deutsche Bank - accounting for around 80% of revenues in 2020
• credit rating agencies: The credit rating agency industry in the UK is dominated by three firms - Moody’s, S&P Global, and Fitch Ratings - which together account for around 95% of the global market
• Lloyds Banking Group, Barclays, Royal Bank of Scotland (RBS), and HSBC - accounted for around 70% of personal current accounts and 80% of small business accounts in 2018.