Market Failure in the Financial Sector

• Asymmetric Information

  -Financial Institutions have more knowledge than customers and in some cases than other financial institutions

  Payment Protection Insurance Scandal

  -Millions of insurance contracts were sold to customers who were taking out a loan, mortgage or credit card-Banks did not investigate whether the insurance was appropriate for individual customers-Customers did not understand what they were being sold-Customers did not know that they could buy the same product for a fraction of the price from another provider
• By packaging together the mortgages, they created complex products which made it very difficult for buyers to understand what they were buying.

  The sub-prime mortgage scandal is believed to be a major reason for the 2008 financial crisis.
• Moral Hazard

  -This occurs when an economic agent makes a decision in their own interest, knowing that there are potential risks, which, if they materialise, will be partially borne by other economic agents.
• Short term risks taken by traders

  -In Investment Banking, traders can earn large bonuses for generating profits for their bank. Incentives seem to be structured to encourage the making of short-term profit so their choices will be skewed and they will be less likely to consider longer term consequences of their actions.-In the 2008 Financial Crisis, banks were accused of pursuing short term profits by taking excessive risk because they knew that banks could never be allowed to fail by the government as they are too important to the economy and they would be bailed out.
• A run on the bank

  A bank run is when a large number of customers of a bank or other financial institution withdraw their deposits at the same time over fears about the bank's solvency. As more people withdraw their funds, the probability of default increases, which, in turn, can cause more people to withdraw their deposits.
• Because banks typically keep only a small percentage of deposits as cash on hand (liquidity ratio), they must increase their cash position to meet the withdrawal demands of their customers.
• Speculation and Market Bubbles

  As almost all trading in financial markets is speculative, this risks creating market bubbles, which is when the price of an asset is driven up to an excessively high level and then collapses.
• Herding behaviour

  -If traders see that the price of an asset is rising, some will view this as an indication that prices will rise further; they will buy into the market, raising demand and hence price further. More investors will follow suit, further increasing demand until eventually prices become too high.-If enough traders decide that the price has peaked, they will cash in and sell which will increase supply and the price will start falling. If panic sets in, large numbers of traders will try to sell too resulting in a price collapse.
• Housing market bubbles

  • Created by financial markets lending too much, particularly to those who may struggle to make payments e.g. in the sub-prime market
  • This created too much demand for houses and led to unsustainable increases in the prices of houses
• Something happens to burst the bubble e.g. a rise in interest rates

  Repayments become more difficult and mortgage defaults rise
• Demand for houses falls

  As buyers are priced out of the market
• House prices reduce

  Owners placed in negative equity as their mortgage values are now greater than the property value
• Owners in negative equity

  Can cause further default and banks are left with loans which will not be repaid in full
• The Housing Market

  -This also reduces consumption in the economy due to the negative wealth effect.-This also creates unemployment in the construction industry and related industries such as estate agents, home improvement retailers etc.-The UK is prone to housing bubbles; (i) because supply is short and this encourages speculation and (ii) because home ownership is so high.-However, other countries such as Japan and the US have also suffered.
• Market Rigging

  Financial Markets are susceptible to market rigging and it takes place when a group collude to fix prices or exchange information  which will lead to a gain for themselves at the expense of others. It is difficult to prove and penalties have been lenient in the past but this changes since the 2008 Financial Crisis. However, the rewards are large so it still occurs.
• Insider Trading

  -This is when an individual or institution has knowledge about a future event but this knowledge is not known to the market.-Based on this knowledge, an asset is bought or sold to make a profit.-This information would be known to have either a positive impact (e.g. news about an impending share offer by a bigger player in a takeover bid) or a negative impact (e.g. an announcement that the firm is pulling out of a big market)
• Externalities

  Financial Markets create negative externalities which are costs borne by other firms, individuals, governments but not the financial market itself.
• Bank Bailouts

  -This occurred during the 2008 Financial Crisis when the UK taxpayer supported financial institutions to the tune of £1.162 trillion, the equivalent of £18,803 per UK citizen (although some of this was guarantees only).-The government did spend £133bn nationalising UK banks and building societies, the equivalent of £2,152 per citizen. This is expected to be repaid in the main as the government sells its shareholdings off.

  -    While the UK government is expected to recoup most of its outlay, this is not the case in Ireland or Greece.
• Financial Crisis

  -The cost of bailouts was small compared to the total cost of the Crisis.-The main cost was in terms of lost output. In the UK, over the last 60 years, the long term growth rate has been 2.5%. If the economy had grown at this rate between 2007 and 2011, GDP per capita would have been £3,811 higher than it actually was.-However, this does not take into consideration the fact that the UK probably had a positive output gap in 2007.-Nevertheless, the crisis did cause a significant loss in output.