Financial Market Failure

Introduction to Financial Market Failure

• Definition: Financial market failure occurs when financial markets do not allocate financial products at socially optimum levels, leading to resource misallocation.

• Purpose of Upcoming Videos: The subsequent video will explore four specific types of financial market failure and how their specific causes relate to the larger themes discussed here.

Excessive Risk Taking

• Concept: Excessive risk can lead to bank failures and systemic risk, endangering the entire financial system.

• Effects of Excessive Risk:

  • Creation and trading of highly risky assets.

  • Increased likelihood of asset failure, leading to wider economic consequences, not just for individual firms.

• Systemic Risk: A bank failure can trigger multiple bank failures, collapsing the entire financial system.

  • Diminished confidence in the banking industry can cripple the economy, impacting jobs and overall output.

  • Past examples include financial crises marked by deep recessions, reminiscent of the 2008 crisis.

  • Potential for taxpayer burdens through bailouts that fund failing banks, resulting in a negative externality.

Collusive Activities in Financial Markets

• Collusion Defined: Financial agents or banks may collude to manipulate interest and exchange rates, compromising market efficiency.

• Consequences of Collusion:

  • Leads to monopoly pricing.

  • Results in loss of consumer welfare and market efficiency.

Historical Context: Deregulation

• Deregulation in the UK and US:

  • Occurred primarily during the 1960s to 1980s, known as the Big Bang.

  • Aimed to transition economies from manufacturing-focused to service-oriented financial industries.

  • Resulted in financial markets expanding significantly.

  • Critics argue deregulation increased systemic risk and financial market failures.

Key Deregulations That Increased Risk

• Capital and Liquidity Ratios:

  • Central regulations were removed, allowing banks to set their own standards, increasing chances of bank failures.

• Reserve Requirements:

  • Prior requirements, which were centrally controlled, were eliminated.

• Commercial vs. Investment Banking:

  • Deregulation allowed combined operations of commercial and investment banking, increasing the potential for risk.

  • Commercial banking funds (generally safer) could be used for riskier investment banking activities.

  • Risk amplification as failure in investment banking could endanger the entire banking entity.

• Reduction of Bureaucracy:

  • While improving efficiency, the removal of regulatory oversight may have unintentionally amplified risks in financial market activities.

Conclusion

• The discussion of excessive risk, collusion, and deregulation provides insight into factors contributing to financial market failures.

• Anticipation for the next video’s focus on specific types of financial market failure.