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Study notes

Financial Market Failure (Financial Economics)

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

This study note looks at examples of market failure in the financial system. Market failure occurs when freely-functioning markets fail to deliver an efficient and/or socially optimum allocation of scarce resources.

Moral hazard

Moral hazard exists in a market where an individual or organisation takes many more risks than they should do because they know that they are either covered by insurance, or that the government will protect them from any damage incurred as a result of those risks.

Asymmetric information

This type of market failure exists when one individual or party has much more information than another individual or party, and uses that advantage to exploit the other party.

Finance is a market in information – often a potential borrower (such as a small business) has better information on the likelihood that they will be able to repay a loan than the lender.

Monopoly / Market-Rigging

This type of market failure is effectively collusion or abuse of a the power resulting from a concentrated market.

When there is a small number of firms in a market, they may choose to work together to increase their joint profits and exploit consumers.

The Competition and Markets Authority report on UK banking in August 2016 said that “the older and larger banks, which still account for the large majority of the retail banking market, do not have to work hard enough to win and retain customers and it is difficult for new and smaller providers to attract customers.”

Speculative Bubbles

A bubble exists when the price of something is driven well above what it should be, usually due to the behaviour of consumers.

Externalities

A negative externality exists when a market transaction has a negative consequence for a 3rd party.

A positive externality exists when a market transaction has a positive consequence for a 3rd party.

We can also talk about network externalities, whereby there are knock-on effects of organisations working together – you could describe this as synergy if the effects are positive, or discord if the effects are negative.

Principal-Agent Problem

This situation exists when one person (i.e. the agent) is able to make decisions on behalf of another person (i.e. the principal), but the principal is unable to adequately supervise the agent. This can result in the agent acting in his/her own best interests rather than the interests of the principal.

Excessive speculation

This can be defined as a risky action in which a person or organisation tries to predict what will happen to the price of an asset and buys / sells accordingly in order to try and make a profit. A speculator takes advantage of fluctuations in market prices.

Incomplete markets

An incomplete market exists when the available level of supply is not enough to meet the needs and wants of consumers i.e. only a proportion of potential demand is met.

  • Around 2 billion adults worldwide without a bank account.
  • 10 million US households, and 1.5 million UK adults are also unbanked

Moral Hazard and Banking Instability

  • Moral hazard happens when an agent is given an implicit guarantee of support in the event of making a loss – for example insurance pay-outs or the guarantee of a bail-out
  • In the commercial banking industry, the belief that the government will absorb the losses that bank creditors would otherwise bear can lead to moral hazard.
  • This may lead banks to take on more risk than is optimal, since they believe they receive any private benefits from the risk taking (i.e. higher profits) while the government will bear the cost of failure (funded eventually by the tax payer)
  • Some institutions may be deemed “too big to fail” – leading to diseconomies of scale and increasing the risk of financial collapse
  • Guaranteeing the deposits of savers might also mean that banks can attract deposits by offering lower rates of interest

The Global Banking Crisis and aspects of Market and Regulatory Failure

  • Irrational exuberance


    • Bank and investors over-optimistic, herd behaviour
    • Failure to understand tail-end risks (or "Black Swan events")
  • Principal agent problem


    • Senior bank executives did not understand complex financial instruments such as CDOs
    • Executives unaware of the scale of leveraged, risky trading
  • Moral hazard


    • Deposit insurance, provision of central bank liquidity, and bail-outs made it rational for banks to take on excessive risk
  • Asymmetry of risk: Gains to private investors, losses absorbed by the public sector
  • Labour market discrimination


    • Would having more women as traders / executives helped to avoid the financial crisis?

Revision Videos on Financial Market Failure

Types of Financial Crisis - revision video
causes of financial crisis - revision video
Consequences of financial crisis (student webinar recording) - revision video

Exam Technique on Financial Market Failure - revision video

A Level Economics Synoptic Essay Guide: Financial Market Failure - revision video

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