Financial Markets and Monetary Policy Flashcards
When does market failure occur?
> Market failure occurs when freely-functioning markets fail to deliver an efficient and/or socially optimum allocation of scarce resources.
List of market failures in financial market
- Moral Hazard
- Asymmetric Information
- Monopoly/Market Rigging
Market failure in financial market - moral hazard
> Moral hazard exists in a market where an individual or organisation takes many more risks than they should do because they know they are either covered by insurance, or that the government will protect them from any damage incurred as a result of those risks.
Market failure in financial market - asymmetric information
> This type of market failure exists when one individual or party has much more information than another individual or party, and uses that advantage to exploit the other party.
Finance is a market in information - often a potential borrower has better information on the likelihood that they will be able to repay a loan than the lender.
Market failure in financial market - monopoly/market-rigging
> This type of market failure is effectively collusion or abuse of a power resulting from a concentrated market.
When there is a small number of firms in a market, they may choose to work together to increase their joint profits and exploit consumers.
The CMA report on UK banking and in August 2016 said that ‘the older and larger banks, which still account for the large majority of the retail banking market, don’t have to work hard enough to win and retain customers and it is difficult for new and smaller providers to attract customers’.
Market failure in financial market - speculative bubbles
> A bubble exists when the price of something is driven well above what it should be, usually due to the behaviour of consumers.
Market failure in financial market - externalities
> A negative externality exists when a market transaction has a negative consequence for a 3rd party, e.g. pay day loans = demerit.
A positive externality exists when a market transaction has a positive consequence for a 3rd party, e.g. pensions, savings = merit good.
Market failure in financial market - excessive speculation
> This can be defined as a risky action in which a person or organisation tries to predict what will happen to the price of an asset and buys/sells accordingly in order to try and make a profit.
A speculator takes advantage of fluctuations in market prices.
Market failure in financial market - incomplete markets
> An incomplete market exists when the available level of supply isn’t enough to meet the needs and wants of consumers i.e. only a proportion of potential demand is met.
Around 2 billion adults worldwide without a bank account.
10 million US households, and 1.5 million UK adults are also unbanked.
Market failure in financial market - moral hazard and banking instability
> Moral hazard happens when an agent is given an implicit guarantee of support in the event of making a loss - for example insurance pay-outs or the guarantee of a bail-out.
In the commercial banking industry, the belief that the government will absorb the losses that bank creditors would otherwise bear can lead to moral hazard.
This may lead banks to take on more risk than is optimal, since they believe they receive any private benefits from the risk taking (i.e. higher profits) while the government will bear the cost of failure (funded eventually by the tax payer).
Some institutions may be deemed “too big to fail” - leading to diseconomies of scale and increasing the risk of financial collapse.
Guaranteeing the deposits of savers might also mean that banks can attract deposits by offering lower rates of interest.
One form of moral hazard stems from regulation.
The Global Banking Crisis and aspects of Market and Regulatory Failure
> Irrational exuberance: bank and investors over-optimistic, herd behavior, failure to understand tail-end risks (or ‘Black Swan events).
Asymmetric Information: senior bank executives didn’t understand complex financial instruments such as CDOs, executives
