4.4.2 Market failure in the financial sector

• Market failure in the financial sector was evident during the Great Recession of 2008
• Asymmetric information


  Banks were not aware of how risky the loans were
• Before the crash, asset prices were high and rising, and there was a boom in economic demand
• There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages
• Borrowers had poor credit histories, and after house prices crashed in the US in 2006, several homeowners defaulted on their mortgages in 2007
• Banks had lost huge funds, and required assistance from the government in the form of bailouts
• Since the crisis, banks have become more risk averse, so there are tougher requirements to get a loan or mortgage
• Externalities


  The effects from an economic transaction on a third party who is not directly involved in the transaction
• Pecuniary externality


  Leads to an inefficient allocation in the market, through prices rather than resources
• In the 2008 financial crisis, illiquidity contributed towards volatility and government intervention
• Liquidity


  Trading activity, liquid assets are those which can be bought and sold easily
• Illiquidity

  Assets that cannot be sold easily without a loss in value, usually because there are insufficient investors willing to buy the asset
• Systematic risk

  The risk of damage of the economy or the financial market, e.g. the risk of the collapse of a bank
• Systematic risks are a negative externality as they cost firms, consumers, the economy and the market
• Moral hazard


  A situation where there is a risk that the borrower does things that the lender would not deem desirable, because it makes the borrower less likely to repay a loan, usually when there is some form of insurance for the mistake
• The financial crisis has been regarded as a moral hazard, due to the degree of risk taking
• Market bubble


  Occurs when the price of an asset is predicted to rise significantly, causing it to be traded more, and demand exceeds supply so the price rises beyond the intrinsic value, then the bubble 'bursts' when the price steeply and suddenly falls to its ordinary level
• A market bubble results in a loss of confidence and it can lead to economic decline or a depression
• Market rigging


  The act of firms coming together to interfere in a market, with the intention to stop it working as it is supposed to, so that the firms can gain an unfair advantage
• Loans such as mortgages, student loans and other financial products use Libor as a reference rate, so manipulating the rate can negatively affect consumers and the financial market