4.4.2 Market Failure in the Financial Sector

What percentage of GDP and employment does the financial sector account towards?

• Approximately 10% of GDP

• 4% of employment

What are the 5 types of market failure in the financial sector?

• Negative externality of production

• Asymmetric information

• Moral hazard

• Market rigging

• Speculation and market bubbles

How is negative externality of production market failure in the financial sector?

• When a bank acts recklessly (i.e. lend to individuals / businesses who have a high chance of default) and fails, everyone suffers. Other banks decrease lending to increase their liquidity, leading to a decrease in real GDP and an increase in unemployment. Any bank bailour is borne by taxpayers.

How does asymmetric information show market failure in the financial sector?

• Financial institutions have more knowledge of their products than

  customers

What is an example of asymmetric information in the financial sector and what are its problems?

• PPI insurance (if a homeowner became the ill, or lost

  their job the insurance would cover their mortgage).

• Ineffective – structured to limit the chances of a payout to

  someone who was genuinely ill.

  ● Mis-sold – without the customers knowledge, or sold as

  "essential", or sold to people such as the self-employed who

  would never be able to claim.

  ● Inefficient – with claimants facing lengthy delays or complicated

  claims procedures.

How does a moral hazard showcase market failure in the financial sector?

• Banks would act recklessly because they knew that if they did fail,

  the government would bail them out.

• This is to ensure savers that their deposits are protected. Without savings, loans can’t be given out.

Define speculation.

• The practice of buying and selling assets or financial instruments with the primary goal of profiting from short term price movements

Define Market Bubbles.

• Where the price of a particular asset rises massively then falls

How do speculation and market bubbles showcase market failure in the financial sector?

• Market bubbles happen when investors see the price of an asset is rising and so decide to purchase this asset as hey believe the price will continue to rise and will profit them in the future

• This leads to prices becoming excessively high and eventually enough investors decide that the price will fall, so they sell their assets and panic sets in causing mass selling (herd behaviour)

Explain why a market bubble may occur in the housing market?

• The financial market has also caused market bubbles in the housing market by handing out too many mortgages and increasing demand for houses. When this bubble bursts, for example due to a rise in real interest rates, there is a fall in demand for houses and a negative wealth effect, reducing AD, and banks are left with loans that will not be repaid in full.

Define Market rigging

• Where a group of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expensive of other participants in the market

How does market rigging lead to market failure in the financial sector?

• One example of this is insider trading, where an individual or institution has

  knowledge about something that will happen in the future that others do not know and so can buy or sell shares to make a profit. Another example is where individuals or institutions affect the price of a commodity, currency or asset to benefit themselves, for example large trades in a currency will shift its value and this will make a difference to individuals selling or buying assets with that currency

What is an example of market rigging in real life?

• Libor scandal of 2008, financial institutions were accused of fixing the London Interbank Lending Rate (LIBOR), one of the most important rates in the world.