4.4.2 - Market failure in the financial sector

• Asymmetric information occurs when one party in a transaction has more information than the other. In the financial sector, this can lead to adverse selection and moral hazard problems.
• Moral hazard: Arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information. For example, borrowers may take on excessive risks if they believe they won't bear the full consequences of their actions.
• Negative externalities: Financial institutions may engage in risky practices (e.g., excessive lending) that can lead to systemic risks affecting the entire economy. The 2008 financial crisis is an example of negative externalities.
• Moral hazard refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their actions
• In the financial sector, moral hazard can arise when banks and financial institutions believe they will be bailed out by the government in the event of a financial crisis. This can lead to reckless behaviour and excessive risk-taking.
• Speculation involves buying assets (e.g., stocks or real estate) with the expectation of profiting from price increases, rather than from the asset's intrinsic value.
• Market bubbles occur when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance. Bubbles often burst, leading to market crashes and financial instability.
• Market rigging refers to the manipulation of financial markets to gain unfair advantages.

  • 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
• Market rigging undermines market integrity and can lead to investor losses.