7- Market failure in financial market

Question 1

Causes of market failure in the financial sector

Answer 1

• Asymmetric information
• Externalities
• Moral hazard
• Speculation and market bubbles
• Market rigging

Question 2

How asymmetric information causes market failure?

Answer 2

• Financial institutions often have more knowledge compared to their customers.
• Between financial institutions and regulators
• May cause lack of regulation and harmful activities

Question 3

Example of asymmetric info

Answer 3

The Global Financial Crisis was partially caused by banks selling packages of prime and subprime mortgages, but advertising them as all prime mortgages

Question 4

How externalities causes market failure?

Answer 4

There are a number of costs placed on firms, individuals and the government that the financial market does not pay.

Question 5

Examples of externalities

Answer 5

• The tax payer’s money bailing out banks in 2007-08

- Long terms on demand and growth due to the crisis

Question 6

How moral hazard causes market failure?

Answer 6

• Financial institutions take excessive risk as they know the BofE can bail them out or the gov.
• Workers may take excessive risks knowing that the worst that can happen is they lose their jobs.

Question 7

Examples of moral hazard

Answer 7

In 2008, employees kept selling mortgages to those who couldn’t repay them to raise their salaries and they didn’t see huge negative effects when the mortgages couldn’t be repaid.

Question 8

How speculation and market bubbles causes market failure?

Answer 8

Almost all trading in financial markets is speculative and this leads to the creation of market bubbles, where the price of a particular assets rises massively and then falls. They tend to occur because investors see the price of an asset is rising and so decide to purchase this asset as they believe the price will continue to rise and will profit them in the future. This
leads to prices becoming excessively high and eventually enough investors decide that the
price will fall, so they sell their assets and panic sets in, causing mass selling.

Question 9

Examples of market bubbles

Answer 9

• 2008- demand for house too high due to excessive mortgages leading to a rise in house prices
  When the bubble burst due to a rise in interest rates there was a fall in demand for houses so a fall in AD (negative wealth effect).

Question 10

How market rigging causes market failure?

Answer 10

This is where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of other participants in the market.

Question 11

Examples of market rigging

Answer 11

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.
LIBOR scandal

Question 12

Insolvency meaning

Answer 12

Insolvent means you have insufficient assets to meet your liabilities.

Question 13

Bank run meaning

Answer 13

A bank run occurs when there is a sudden demand to withdraw money from a bank, that the commercial bank struggles to meet.