Financial Market Failure

A-level Economics

This page will teach you about the different kinds of financial market failure and why this can harm social welfare. After you study this page, please go to the page on regulation to learn how we combat financial market failure.

Systemic Risk

A systemic risk is where the failure of one bank can cause problems for the whole financial system and even the economy. This is because banks are at the heart of the economy.

Timeline example of how a bank could fail and cause the financial system to fail:

1. Easy access to credit, low interest rates, and increased lending

2. There is an extended period of economic prosperity

3. A sudden fall in the price of assets (like houses or shares) causes panic

3. Increased defaults on loans and increased selling of properties

4. Asset prices begin to plummet

5. Banks become illiquid and bad news reaches the customers

6. This can cause a bank run, so customers may want to with draw all their deposits from their accounts

7. The bank fails

These failures can spread throughout the economy - this is why there is a systemic risk. A failure in one bank might lead to failures in other banks and perhaps the whole financial system.

Banks are international institutions doing business all around the world. They affect everyone.

Market Bubbles

Banks are also partially responsible for creating market bubbles.

A market bubble is when people speculate about assets and how they might increase in value over time.

This leads to an increase demand for the asset - asset prices increase beyond their true value.

When confidence is lost, people begin to sell. This decreases the price of the asset -> people start selling -> prices of assets fall sharply.

This problem can be related to "animal spirits" [Keynes].

Summary of the Financial Crisis of 2008

1. Speculative bubble in the US housing market (people thought house prices would always rise)

2. Banks start lending out money to anybody they can, even sub-prime borrowers. Sub-prime

mortgage market begins to explode.

[Sub-prime borrowers are borrowers with bad credit histories who should not really be lent large sums of money]

3. Banks continued to lend money (even to sub-prime borrowers) because they thought the loans were secured against the value of the homes.

4. People started defaulting on these mortgages -> house prices begin to fall.

5. Banks now have a large stock of houses (fixed assets) with no money income on mortgages that were lent to borrowers.

6. Confidence was lost throughout the economy -> people stopped buying houses -> further decrease in house prices -> the banks were stuck with all of these fixed assets, meaning a liquidity crisis.

7. This caused the "credit crunch" -> banks had no available money to lend

8. This all decreased economic growth to negative levels.

Externalities within the Financial Markets

Externalities are costs to a third party. These are not paid for by the free market. Externalities exist in financial markets.

One example of a negative externality is bad risk management. Bad decisions affect all stakeholders.

These stakeholders could be depositors, shareholders, governments, taxpayers, the economy (GDP down, unemployment up).

Asymmetric Information

Asymmetric information occurs when information is not perfect. It is when one side of the transaction has more information than the other side. E.g. the buyer knows less than the the seller.

This is the case in the banking industry. Banks know more about their products and how they work compared with borrowers. This can lead to confusion when purchasing financial products.

An example of this is the PPI (Payment Protection Insurance) scandal.

Another example of asymmetric information is that borrowers know more about themselves and their ability to repay loans than banks do.

A risky borrower will not disclose to the bank that they are risky. They will overstate their incomes and they will overstate their creditworthiness. This is called the "adverse selection problem".

Adverse selection can lead to the banks taking greater risks than they intend to.

If a borrower doesn't tell the bank the truth, then the bank cannot accurately calculate risks.

The same problem exists in other markets, especially insurance.

This is why we have agencies that gather information about people to prevent people lying and to provide more accurate information to the banks. One such company is Experian who hold information about people's credit histories.

A problem stemming from information asymmetry is that less risky customers are charged more by banks on their loans and insurance policies.

The Moral Hazard Problem

Moral hazard is when the actions of somebody changes after they are insured. It is not known to the insurer about the true actions of a person after they are insured. This is due to information asymmetry.

Once somebody is insured, their actions are likely to become more risky than the actions of an uninsured person. This makes sense right? If you were uninsured and were driving a car, you would be much more careful and aware when driving on the road.

If banks have insurance against failure, then banks will take more risks too because of the moral hazard problem. Banks realise that if anything should go wrong with their lending activities they might get a government bailout.

Bank bailouts often occur because the banks are considered to be "too big to fail". Letting a bank fail can have severe consequences on the rest of the economy. Governments have no choice but to bail out banks otherwise the consequences would be worse.

There would be mass panic and bank runs. There would be billions lost and confidence would take too long to restore..

Market Rigging

Market rigging occurs when there is collusion in the financial markets. It occurs when banks collude with one another to deliberately manipulate markets so they can make a profit.

For example:

1. Banks want to manipulate the price of a stock and make a profit.

2. The invest billions in to the stock.

3. The stock price inflates.

4. People start taking notice ("why is this stock going up so quickly")

5. More people buy into the stock. The price goes up further.

6. When the price reaches a target level, the bank sells all of its shares.

7. The price of the stock plummets.

8. Normal people lose a lot of their money as the price of their assets have decreased.

This is particularly a problem in the market for penny stocks.

There needs to be laws that prevent market rigging and correct this failure. However, the punishment has to be more severe than the profits of the crime.

Please go to the next page where we will look at regulating the financial markets.

In summary, we have learned: