Financial Market Failure Flashcards
a financial crisis can create a
systemic risk
examples of financial crises
a sudden sharp fall in the price of assets (shares or houses)
government defaulting on its loans
when do financial crises seem to happen
after a long period of prosperity (because of low interest rates, easy credit, excessive speculation and overconfidence)
this often leads to a recession.
systemic risk
the risk that a problem in one part can lead to the breakdown of the whole market or perhaps even the whole financial system.
problems in one country’s financial system can also spread around the world.
what does speculation mean
aiming to make a profit by buying assets relatively cheaply and selling them at a higher price.
if assets loose value you loose money. therefore there is a risk.
what can create market bubbles and why is this bad?
excessively high estimates of future asset price rises can lead to market bubbles
investors expecting the price of an asset to continue to rise can overpay, creating a market bubble.
when investors eventually lose confidence, the bubble will burst and investors will rush to sell their assets to avoid large losses. this leads to prices plummeting, leaving investors with large debts (if they borrowed the money they invested) and worthless assets.
what is a market bubble
where prices in a market are much greater than the assets true worth.
what do speculators often do?
therefore
they often borrow the money to fund their purchases.
banks can help to create market bubbles if they give out credit too easily.
financial crisis of 2008
partially caused by a speculative bubble in the US housing market.
Growth in the sub-prime mortgage market (the mortgage market for borrowers with poor credit rating) caused house prices to rise, as demand increased.
this lead to more people investing in property, pushing prices up further.
The bubble burst when people began to default on their mortgages. This caused house prices to fall.
The banks level of capital fell. Banks reduced lending, creating a credit crunch.
This triggered a loss of confidence in the wider economy, a fall in aggregate demand, and a deep recession.
credit crunch is when
The credit crunch refers to a sudden shortage of funds for lending, leading to a decline in loans available.
externalities in the financial markets
mismanagement of risk is one cause of externalities. for example, the risks financial institutions tool that eventually led to the 2008 financial crisis were paid for by taxpayers, government money was used to prevent the collapse of major banks.
other negative externalities during the 2008 financial crisis include, large drops in GDP, falling salary levels, significant rise in unemployment.
why did the government have to use taxpayer money to bail out the big banks.
because some were considered too big to fail.
they had become so big that a systemic risk was created.
if one or two of these large banks collapsed, if could have led to panic and a run on other banks, causing them and possibly the whole financial sector to collapse.
the UK gov felt it has to rescue these banks, even though it cost billions of pounds.
example of adverse selection
eg in life insurance include situations where someone with a high-risk job, such as a race car driver or someone who works with explosives, obtain a life insurance policy without the insurance company knowing that they have a dangerous occupation.
adverse selection
Adverse selection is when sellers have information that buyers do not have, or vice versa, about some aspect of product quality. It is also the tendency of those in dangerous jobs or high-risk lifestyles to purchase life insurance.
moral hazard
is the concept that individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.
