market failure in the financial sector Flashcards
what is an example of market failure in the financial sector?
great recession of 2008 in US
how does asymmetric information cause market failure in the financial sector?
- before the crash asset prices were high and rising and there was a boom in demand
- there were risky bank loans and mortgages which means that the borrowers had poor credit history
- after house prices crashed in the US several homeowners defaulted on their mortgages
- fail to make several of their payments
- banks had lost funds and required assistance from the govt in the form of bailouts
- there was asymmetric information as banks werent aware of how risky the loans were
- since the crisis banks have become more risk averse so theres tougher requirements to get a loan or mortgage
what are pecuniary externalities?
a pecuniary externality leads to an inefficient allocation in the market through prices rather than resources
- could lead to under provision of liquidity in the banking model
- could lead to volatility and gov intervention
what is liquid assets?
those that can be bought/sold more easily
what is illiquidity?
- assets that cant be sold easily without a loss in value
- usually because there are insufficient investors willing to buy the asset
how do percuniary externalities cause market failure in the financial sector?
- could lead to under provision of liquidity in the banking model
- could lead to volatility and gov intervention
what are systematic risks?
- systematic risk in financial markets can be seen as a negative externality
- systematic risks are the risk of damage of the economy or the financial market
- e.g it could be the risk of collapse of a bank
- this costs firms, consumers, the economy and the market its said to be a negative externality
how do moral hazards cause market failure in the financial sector?
- this is where there is a risk that the borrower does things that the lender wouldnt deem desirable as it would make the borrow less likely to repay a loan
- occurs when there is some form of insurance for the mistake
- e.g if a house is insured a borrower might be less careful as they know any damage will be paid for by someone else
- banks may take more risks if they know the bank of england or the govt can help them if things go wrong
- the financial crisis has been regarded as a moral hazard
how does speculation and market bubbles cause market failure in the financial sector?
- a market bubble occurs when the price of an asset is predicted to rise significantly
- this causes it to be traded more
- demand exceeds supply so the price rises beyond intrinsic value
- the bubble then bursts when the price steeply and suddenly falls to its ordinary level
- causes panic and investors try to sell their assets
- results in a loss of confidence and can lead to economic decline/ depression
what are market bubbles?
a market bubble occurs when the price of an asset is predicted to rise significantly
what is market rigging
Collusion amongst traders or financial institutions can lead to higher profits at the expense of others
e.g banks may attempt to operate an interest rate cartel, so that interest rates to savers are lower, and to borrowers higher than would be the case in a more competitive market
e.g the Libor scandal
what is a financial market failure
refers to situations where financial markets fail to operate efficiently causing lost economic output
this means the price mechanism doesnt work effectively
occurs when money, equity and bond markets dail to achieve an efficient or equitable outcome
how can market rigging lead to market failure in the financial sector
damage consumer/business confidence so they may not be willing to participate in the market
