Market Failure in the Financial Markets Flashcards
What forms of market failure can exist in Financial Markets?
- Asymmetric Information.
- Moral Hazard.
- Externalities.
- Speculation.
- Asset Price Bubbles.
- Market Rigging.
What does Asymmetric Information mean?
One side of the market holds more information than the other side of the market, and exploit this position.
What examples are there of Asymmetric Information in the Financial Markets?
- Insurance Market: Sellers have missing info about buyers who have full info about their behaviour (may hold risky info back to get cheaper insurance). No insurance = low risk, full insurance = high risk - so insurance costs are high to account for this risk.
- Subprime Mortgage Market: Sellers of mortgages have missing info about the buyers ability to pay back the mortgage, whereas buyers do. If a buyer defaults on their payment once, no problem, but many times, big problem (catalyst for the 2008 financial crisis).
- Risk of Financial Products: Sellers have full info on how risky an asset is, whereas buyers don’t. Buyers of assets/securities can never be too sure about the real level of risk behind an asset, resulting in them being cautious about investing into portfolios (e.g. CDOs in 2008).
What are the forms of Asymmetric Information?
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Moral Hazard = when a behaviour of individuals change after a contract is agreed and enforced.
- E.g. Lenders of Last Resort - implicitally guarantee against bank failures which encourages risk taking behaviour of banks (as they know they’ll be bailed out by taxpayers).
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Adverse Selection = Private sector info means only those who benefit will enter into a contract.
- E.g. Only the riskiest want insurance - this pushes up insurance prices and coverage lower (leads to allocative inefficiency).
How are Externalities present in the Financial Markets?
Costs generated by banks which are passed on to the real economy via a recession. This was seen in the Great Depression and the 2008 Financial Crisis.
Which Negative Externalities were generated during the 2008 Financial Crisis?
- Fall in annual growth rate.
- Collapse in GDP.
- Sharp rise in unemployment.
- Drop in disposable income.
- Financial contagion.
- Taxpayer burden - banks fail and must be bailed out.
What does Speculation mean?
Investing in an asset/security in the anticipation that the value will rise over time. This is dangerous because the value of assets becomes artificialy high and over valued (price bubble).
Why do Price Bubble’s form?
No economic fundementals behind the investment decision undertaken, mainly herd behaviour.
What examples in history are there of Price Bubbles?
- Tulip Mania: Fahsionable interest in ‘horticulture’ (status symbol). Investors bought into tulip bulbs. Non-fatal virus caused tulips to blossom in rare colours which attracted speculators, increasing the value further. Bubble burst hurting investors.
- Dow Jones Industrial Average (daily closing price): Jan 2016 - price around $17k. Due to low interest rates, people were not getting a return on their savings so invested into the stock market. This caused prices to increase from $17k Jan 2016 to nearly $27k in Dec 2017. Feb 2018, bubble burst causing prices to fall (10% correction in the market when people realised the market shouldn’t be behaving this way).
Why do Price Bubbles matter for Banks and Financial Institutions?
Banks have large balance sheets composed of different asset classes. Herd behaviour in markets leave banks exposed as risk spreads to investors with a vested stake in the bank.
This affects consumption and AD in the real economy. This creates conditions for an economic recession - high unemployment and falling disposable incomes (“Minsky Moment”).
What is the “Minsky Moment”?
Refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. Named after the economist Hyman Minsky, and defines the point in time where the sudden decline in the market sentiment leads to a market crash.
What is Market Rigging?
Individuals and companies working together for a mutual benefit to stop a market operating as it should do.
It normally results from rogue bankers in a financial institution fixing some aspect of the market to make a substantial return.
What examples have their been of Market Rigging?
- FX market Rigging: Rogue bankers shared private info in chat rooms to make cash. Bankers knew which transactions would take place and direction of the currency swing. They would then bet on the direction of this currency swing to make more profit.
- LIBOR Scandal (2012): London Interbank Offered Rate - provides a measure of the health of the finance system. When confidence is high banks lend at lower interest rates to eachother, but when it is lower, they lend at higher rates. Banks, e.g. HSBC + Barclays, colluded on rate submission for their own benefit (said they were lending at a lower rate to make their banks look stronger - lower rate indicates their trsutworthy and credit worthy, i.e. no risky) which in turn boosts profit.
What are bank failures concerned with?
- Solvency position of the bank (banks are solvent if the value of assets are equal to the value of liabilities).
- Liquidity Problems
What determines the solvency position of the bank?
- If the value of assets falls below the value of liabilities, any spare capital that the bank has can absorb the loss of assets and the bank can remain solvent.
- If there is not enough spare capital to make up the loss in assets, the bank is insolvent because the value of liabilities is greater than the value of assets and spare capital.
- Important for enough capital on balance sheet (liquidity position of bank).
