4.4.2 Role Of Market Failure Flashcards
1
Q
How can market failure be related to financial markets?
A
- when market mechanisms leads to a misallocation of resources
- economists argued that market failure in the financial markets contributed to the 2008 financial crisis
- the act of lending too many risky financial products to too many risky customers
- this has led to an increased regulation of the financial markets
2
Q
Examples of market failure?
A
- asymmetric info
- moral hazard
- negative externalities
- speculation + market bubbles
- spread of lending
- irrational behaviour
- market rigging
3
Q
Asymmetric info in financial markets?
A
- one party has more knowledge of the extent of the risk than another
- the buyer is likely to have less knowledge of risk than seller
4
Q
Moral hazard
A
- one party may take more risk than it should because they are provided with a safety net
- e.g. the banks were too big to fail = so they could take risks with who they leant to as they could be bailed out if they made a loss + kept the profits when they were successful
5
Q
Negative externalities
A
- banker in their lending behaviour did not fully take into account the knock-on effects (contagion) of the ‘external cosrs’ of managing risks
- borrowers defaulted on their loans + this had far reaching consequences on the national + global economy
- financial crisis triggered significant falls in GDP, rising unemployment + falling incomes
- bankers enjoyed the profits during the good years but taxpayers had to pay the losses after the crisis on account of the too big to fail problem
6
Q
What is systemic risk?
A
When the collapse of an individual bank can trigger instability across the whole financial sector
7
Q
What is the speculative bubble?
A
- a sharp + steel rise in asset prices such as shares, bonds, housing, commodities
- the bubble is usually fuelled by high levels of speculative demand (and an asset is demanded because the buyer believes it will continue to go up in price) which takes prices above fundamental value
8
Q
Speculation + bubbles example (financial crisis)
A
- housing markets have exhibited speculative bubbles over the years
- the sub-prime housing boom in the US is regarded as one of the root causes of the financial crisis
9
Q
Forms Speculation + market bubbles
A
- poor lending decisions by bankers encouraged by low interest rates set by central banks —> lenders mistakenly believe good times will continue + property prices will keep increasing so they lend to riskier borrowers once all safer borrowers have a mortgage
- managers also continued to lend due to incentives = received a percentage of the growth on loans + lend knowing banks are too big to fail (moral hazard)
10
Q
What is negative equity?
A
- when the value of the mortgage is greater than the value of the house
- consequence of speculation in the housing market
11
Q
What is a housing bubble?
A
- excessive lending to home buyers who have no deposit and/or poor credit score
- prices increase beyond sustainable levels
- when borrowers can repay, homeowners try + sell the property to repay the bank
- there is an increase in supply of houses on the market
- prices fall + bubble bursts
12
Q
Spread of lending
A
- lending to spread to a range of sectors not just the housing market
- human greed led to excessive lending
- people couldn’t repay = debts get passed on + there is a knock on effect leading to the collapse of the market
13
Q
Irrational behaviour
A
- supporters of markets suggest individuals behave rationally + think through a decision —> but this is not always the case
- e.g. herd behaviour = following others
14
Q
What is market rigging?
A
- involves illegally fixing the price of interest rates/exchange rates through collusion amongst bankers (UK banking is an oligopoly)
- can involves some insider trading e.g. sharing of information = some asymmetric info
- bankers increase profits as a result + consumers lose out
15
Q
What is Libor?
A
- London inter bank offer rate
- rate of interest banks use when they lend to one another
- form of market rigging
