There are five types of market failure in the financial sector:
- Asymmetric information
- Asymmetric information occurs when one party has more information than another in a transaction.
- One type of asymmetric information is “adverse selection”. This occurs when either buyers or sellers have more information than the other party about some measure of “quality”.
- When a bank lends to a borrower, the bank may not know the creditworthiness of the borrower. In other words, whether the borrower is likely to repay the money or not.
- This makes banks increase interest rates on loans to compensate for this uncertainty about whether borrowers will repay. However this makes borrowing unaffordable for some potential borrowers, for example making it harder for firms to access loans.
- A similar problem applies with insurance. Insurers do not know whether the insured party is a high risk or low risk party to insure. For example with car insurance, the insurer does not know whether the driver is a safe or risky driver.
- A third example is CDOs (collateralised debt obligations). These are financial products that repackage a bunch of loans, such as mortgages, into one asset.
- Buyers of CDOs may have been unaware of the risk involved in buying the CDOs. However sellers, such as financial institutions and banks, may know more about the risk levels of these CDOs, which may have included high-risk mortgage debt. In this case a lack of information led to CDOs being overpriced, as buyers assumed the CDOs were safer than they actually were.
- However credit rating agencies should give potential buyers information about the level of risk from buying different financial products. Yet part of the cause of the financial crisis was that credit rating agencies did not correctly rate the risk level of CDOs.
- More generally, adverse selection problems can be prevented when regulators force sellers to provide information or face legal penalties such as fines.
- Technological solutions such as drivers agreeing to having their car usage tracked and evaluated could reduce car insurance prices.
- In the case of bank lending, borrowers could signal their creditworthiness by providing collateral (assets offered up in case of failure to repay) or strong credit scores.
- Another example of asymmetric information is moral hazard (see further down the page).
- Externalities
- The banking sector is linked with the rest of the economy. It provides a way for households to save and for firms to borrow.
- Risky activity in the banking sector can generate significant negative externalities (see below).
- Failure of one bank affects other banks. For example, if one bank can no longer repay a loan, this reduces the revenue for another bank.
- Failure of the banking system can affect the wider economy. This is known as systemic risk – problems at an individual financial institution can trigger a macroeconomic downturn.
- Investment falls. Banks give out fewer loans. They may need funds in reserve to cover liabilities (deposit withdrawal). As banks give out fewer loans, firms cannot get funding for investment. So investment falls.
- Consumption falls. The risk to deposits from bank failure may reduce consumer confidence, reducing consumption. Suppose consumers lose their deposits or part of their deposits if a bank fails. Then they experience a negative wealth effect, reducing consumption.
- Altogether, this means a significant fall in aggregate demand. So lower real GDP, higher unemployment and lower inflation occur.
- However, regulations such as minimum reserve requirements (banks having to hold a minimum amount of money in reserves to protect against bank failure) may reduce the likelihood of bank failure. This would reduce the likelihood of any negative externalities being generated.
- Moral hazard
- Moral hazard is when being insured against a risk makes the insured party more likely to engage in risky behaviour.
- Moral hazard is also a type of asymmetric information.
- Leading up to the 2008 global financial crisis, banks engaged in risky behaviour such as investing in riskier financial assets. In part this may be because the banks believed that the government would bail out the banks, offering financial support, if they failed.
- Bailing out involves the government giving money to banks to prop them up and prevent their failure. This indeed happened, with banks such as Royal Bank of Scotland in the UK.
- However following the financial crisis, there are now alternative options for regulators when a bank fails.
- This can include making shareholders in the bank pay for losses incurred from the bank failing, while keeping the bank open or transferring the bank to another owner. This enables customers to keep using the bank, without creating moral hazard for banks and shareholders.
- Speculation and market bubbles
- Speculation occurs when investors believe that the price of an asset will continue rising. To capitalise on this, investors buy the asset and hold it.
- This increased demand for the asset, which can lead to the price rising above the asset’s fundamental value – this is called a market bubble.
- Bubbles can burst. In the case of a market bubble, speculators may suddenly realise the asset is priced above its true value. This leads to lots of investors selling the asset at once, leading to a fall in the asset’s price and leaving some speculators much worse off.
- An example of this is the housing market in the lead up to the 2008 financial crisis. Banks and investors speculated that house prices would continue to rise, contributing to greater lending to low income households. When these households could no longer make mortgage payments, the housing market and related financial assets fell in value – the bubble burst.
- Market rigging
- Market participants could coordinate to fix market interest rates or exchange rates in their favour.
- An example of this is the Libor scandal.
- Libor is a benchmark interest rate used in certain financial transactions, for example in borrowing funds from other banks on a short term basis.
- A set of traders were convicted for rigging the Libor rate.
- However regulations such as fines or jail time for rigging rates may disincentivise market rigging.
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