Market Failure in the Financial Sector 4.4.2

Question 1

Asymmetric Information in practice

Answer 1

Finance is a market in information – for example, often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.

• financial institutions tend to have more knowledge than consumers.

Question 2

Moral hazard

Answer 2

exists where an individual or organisation takes more risks because they know that they are covered by insurance, or they expect that the government will protect them (i.e. bail them out) from any damage incurred as a result of those risks.

Question 3

With moral hazard

Answer 3

agents behave differently in the knowledge that they are insulated from risk i.e. someone else will cover potential future losses.

Question 4

Speculation and bubbles in financial markets

Answer 4

• A speculative bubble is a sharp & steep rise in asset prices such as shares, bonds, housing, commodities or crypto currencies.
• The bubble is usually fuelled by high levels of speculative demand which takes market prices of financial assets well above fundamental values.

Question 5

What factors can cause a speculative bubble?

Answer 5

• Behavioural factors e.g. the herd behaviour of investors.
• Exaggerated expectations of future price rises (i.e. people expect property prices to carry on increasing).
• Irrational exuberance of investors – a term coined by Nobel-winning economist Robert Shiller.
• A period of very low monetary policy interest rates – which encourages risky investment by people and by other agents in financial markets in search of higher yields.

Question 6

Examples of barriers to entry into commercial banking

Answer 6

1. Regulatory barriers – i.e. the need to be given a banking licence by the central bank.
2. Natural or intrinsic barriers to entry – the costs of entering the market include marketing costs, building reliable and secure IT and payments infrastructure
3. Strategic advantages of larger banks – including gains from vertical integration, a branch network and low rates of customer switching – many people are reluctant to swap accounts & have strong default behaviour
4. First mover advantages - including strong brand loyalty for established banks

Question 7

What is systemic risk?

Answer 7

Systemic risk is the possibility that an event at the micro level of an individual bank / insurance company could then trigger instability or collapse an industry or economy.

Question 8

Bear Market

Answer 8

Market where prices are falling against background of gloomy investors

Question 9

Bond

Answer 9

Lower to medium risk loans to the government or companies

Question 10

externalities in financial markets

Answer 10

There are a number of costs placed on firms, individuals and the government that the financial market does not pay . One example of this is the cost to the taxpayer of bailing out the banks after the 2007-8 financial crisis . Even higher than this, was the long-term cost to the economy of the crisis due to its effects on demand and growth. Moral hazard also shows some external costs