4.4.2 Market Failure in the Financial Sector

Asymmetric information

• Many financial products are complex & difficult for consumers to understand
• The sellers often have a significant information advantage over the buyers
  • E.g. During the financial crisis, financial institutions bundled thousands of mortgages together & sold them on to investors. The sellers had more information on the risk profile of each bundle than the buyers
  • E.g. Mortgage sellers often understand the implications of interest rate changes to repayments much better than the average consumer
• The Global Financial Crisis demonstrated that asymmetric information even exists between financial markets & the regulators set up to monitor them

Externalities

• Negative externalities of production & consumption exist in financial market
  • E.g. When investors speculate  on property prices, a negative consumption externality occurs as young buyers end up paying more (or being forced out of the market) due to the higher prices caused by speculation (AirBnB effect)
  • E.g. When banks in many developed nations relaxed mortgage lending requirements this helped cause the Global Financial Crisis. The impact of the crash reverberated around the world causing a global depression which reduced or eliminated imports from many developing countries (third parties to the global mortgage market)

Moral hazard

• Moral Hazard has increased in the financial sector since 2008 as Governments have stepped in to save individual banks from failure (e.g. RBS)
  • Banks seem to be considered 'too big to fail' & governments bear the consequences of their risky behaviour
  • The financial sector returned to questionable practices within two years: The China Hustle documents how investment funds & stockbrokers played up obscure Chinese companies who presented fake financial data. This stimulated investor demand, temporarily pushing up prices. Many investors lost a lot of money

Speculation & market bubbles

• The higher the money supply in an economy, the greater the speculation & potential for market bubbles
  • Significant amounts of quantitative easing since 2008 have increased the money supply & created potential bubbles in different markets (e.g. property, cryptocurrency, shares)

Market rigging

• There have been allegations that some banks & individual bankers have been involved in rigging key interest rates or exchange rates in order to profit maximise
• This is considered to be fraudulent activity but is often difficult to identify or trace unless there is a whistleblower who reveals the fraud