Market Failure in the Financial Sector Flashcards
What are the 5 examples of market failure in the financial sector?
1) Asymmetric information.
2) Market rigging.
3) Externalities.
4) Moral hazard.
5) Market bubbles and speculation.
What is market failure?
When free markets fail to deliver an efficient/socially optimum allocation of resources.
What is asymmetric information, and how can it lead to market failure in the financial sector?
When one party in a transaction has more information than the others. This can lead to exploitation of the information gap, and the inability of consumers to make rational decisions.
What are externalities, and how can they lead to market failure in the financial sector?
Costs paid by other individuals, firms or governments, but not the financial markets creating the costs. E.g. during the financial crisis of 2008, governments, and therefore the taxpayer, had to support and bail out financial institutions.
What is moral hazard?
The willingness to take risks, due to the understanding that if anything goes wrong, someone else will pay the costs.
Explain the market failure caused by PPI contracts in the 1990s and 2000s (3).
1) Banks sold millions of insurance contracts - payment protection insurance (PPI) - to customers taking out mortgages, credit cards and loans.
2) These contracts were often not appropriate for the needs of the consumer, but the detail/info was so complex that consumers did not challenge.
3) This was an example of market failure, as more consumers paid for the PPI than what would have without the information gap.
How much did the British government spend nationalising banks and building societies during the financial crisis of 2008?
£133 billion.
What is speculation?
The buying of assets at a relatively low price, with the aim of making a profit by selling them at a higher price later on. This often has significant risk of a loss, but this is offset by the possibility of huge gain.
What are market bubbles?
When the price of an asset is forced excessively high, beyond its true value, before falling back down.
What can market bubbles also be known as?
Asset price bubbles.
What is market rigging and give an example?
1) The manipulation of financial markets to gain unfair advantages.
2) Examples include insider trading (trading based on non-public, material information), market manipulation (e.g., pump-and-dump schemes), and collusion among market participants to distort prices.
What was the LIBOR scandal of 2007?
When a group of banks (including Barclays, Citigroup and the Royal Bank of Scotland) worked together to fix the London Interbank Offered Rate (LIBOR), an average interest rate used to globally fix other interest rates, in their favour.
What is shadow banking?
Borrowing and lending outside of the regulated banking sector. E.g. hedge funds, private equity funds, derivates trading, crowdfunding, etc.
What is systemic risk?
The risk of breakdown of an entire financial system, rather than the failure of individual parts within the system.
What 2 factors have contributed to an increase in systemic risk?
1) Insufficient separation between a banks commercial and investment banking activities - the Vickers Report of 2011 recommends that the commercial arm of a bank is ringfenced from the riskier investment banking activities.
2) The growth of the shadow banking system - as financial markets are interconnected, the failure of an unregulated shadow bank could bring down a ‘safe’ bank.
