Practice Exam Questions
Financial Market Failure (Revision Essay Plan)
Last updated 1 May 2018
This video looks at a possible answer to this question on financial market failure. "Evaluate the micro and macroeconomic policies that might be used to correct financial market failures in the UK economy."
Financial market failure occurs when money, equity and bond markets failure to achieve an efficient and/or equitable outcome. This can lead to economic and social costs including macro instability and loss of trust and confidence in financial institutions.
Financial market failures include market rigging, speculative bubbles, information failures and low levels of market competition between suppliers.
Micro point 1
One micro policy to address financial market failure would be to provide more licences to encourage smaller challenger banks to enter the industry.
This policy would increase the contestability of retail banking and therefore reduce the monopoly power of established banks such as HSBC and Barclays. More competition can then lead to better outcomes for consumers including lower charges on overdrafts and improved interest rates for savers.
However we know from behavioural economics that consumers have strong default choices when deciding which bank to use, the inconvenience involved in switching means that challenger banks often find it hard to achieve the economies of scale needed to compete effectively.
Micro point 2
A 2nd micro policy would be to introduce price capping on interest rates charged by household loans companies.
Payday loans companies often charge very high interest rates to families which can lead to mounting debt problems and financial distress. A cap on interest charges would reduce the burden of servicing debt for some of the poorest households.
A possible problem with this policy is that lenders will all charge the maximum capped rate rather than compete at lower interest rates. They could also impose extra charges as a way of getting around the price ceiling.
Macro point 1
One macro policy would be for the Bank of England to impose a higher liquidity ratio. This is the ratio of liquid assets held by a bank to their total assets.
If banks are required to hold more liquid reserves, then they will have a stronger capital base to help them withstand a future downturn in the economy which could lead to a rise in loan defaults and bad debts. This will help to promote financial and macroeconomic stability for the UK in the long term.
However there is a risk that stricter controls on bank lending using capital ratios might limit the amount of money that banks are able to lend to businesses looking for debt finance. This could hold back business investment which will hurt long run aggregate supply
Macro point 2
Another macro policy would be for central banks to return gradually towards normal levels of interest rates.
The base rate set by the Bank of England has been below 1% since 2009. Ultra-low interest rates encourages speculative activity in property and equity markets and can lead to an unsustainable bubble with asset prices well above fair value.
A downside of returning to higher interest rates of between 3-5% would be household debt is at historically high levels. Millions of people are vulnerable to sharp rises in borrowing costs, the central bank needs to be cautious.
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