Market Failure in the Financial Sector

Market failure is a persistent problem in financial markets, which is why it is necessary to have strict regulation of banks and other financial institutions. Reckless lending, mis-selling of financial services and outright fraud are all common problems. The main reasons why market failure occurs in financial markets are as follows:

Asymmetric information - A more intractable information problem is to do with quality of goods rather than price. Consumers are often at a disadvantage compared to producers. Economists call this the problem of asymmetric information, where one party to the transaction (usually, but not always the seller) has much better knowledge of the product than the other party. Persuasive and misleading advertising can add to this problem.

Financial services, such as mortgages, life insurance and pensions are very complicated for many people to understand, and they may take it on trust that banks and other financial institutions are acting with integrity when they sell these products.

There have however, been a number of scandals over mis-selling of financial services in recent years, with banks being forced to pay customers compensation for mis-selling, particularly over so called ‘payment protection insurance’ (PPI), where customers taking out loans were also persuaded to take out an insurance policy to pay back the loan if they fell into hardship. These policies often turned out to have a lot of ‘small print’ clauses which made it very difficult for people to claim on them when they needed to.

Because of the complex nature of financial services, many people use a financial advisor or broker to help them choose an appropriate product. This can lead to the so called ___principal-agent ___problem. The ___principal ___is the individual or organisation that may benefit or lose from a transaction. The ___agent ___is the person or organisation acting for them. In this case the person using a financial advisor is the principal, and the advisor is the agent. The problem here is that the agent and principal do not necessarily have the same interests. The advisor may seek to persuade the client to take out a particular mortgage policy because he (the advisor) will earn a large commission from the bank selling it. Again this is a case of asymmetric information (the advisor knows more than the client) and it can lead to market failure and misallocation of resources.

Sometimes there is asymmetric information between financial institutions. The banking crisis in 2007/8 was partly caused by some banks selling on sub-prime mortgages (mortgages loaned to very high risk borrowers who were likely to default) to other banks who were unaware of the risks.

There can also be asymmetric information between financial institutions and regulators; banks may hide some of their activities and the level of risk they are taking from the regulators.

Moral hazard – If an economic agent, whether an individual or a business is able to transfer the risk of their actions onto others moral hazard is said to exist. This can result in an undesirable economic outcome for the economy as a whole. For instance it is often argued that banks believe they are ‘too big to fail’ and can always rely on the central bank and government bailing them out if they get into difficulties, because the authorities fear the economic consequences of a banking failure. This can result in reckless lending to high risk borrowers who may have little prospect of repaying the loans.

Negative externalities _– Sometimes the behaviour of banks can result in serious consequences for third parties, such as bank customers, the government and the wider business community and their employees. The financial crisis of 2007/8 led to a massive bailout of the banks, costing many £billions of taxpayers’ money in many countries. Most of this will never be recovered from the banks as the debt has had to be written off. This means there is less money available for public services, because the bailout led to a huge increase in government borrowing which has to be repaid. The so called period of ‘austerity_’ is likely to last in countries like the U.K. until at least 2020. It has caused particular hardship to poor and vulnerable people who have experienced cuts in welfare benefits.

The financial crisis also resulted in a very severe global recession. Banks greatly reduced their lending, in what became known as the ‘credit crunch’ starving businesses of funding for investment and reducing overdraft credit, forcing many firms into bankruptcy. The recession resulted in higher unemployment and falling wages.

Speculation and market bubbles – Much of the buying and selling in financial markets is by speculators, who trade primarily to make a profit (or avoid a loss). This can often result in ‘herding’ behaviour; for instance if the price of gold has been rising, it is taken as an indication that it will go on rising, leading to a ‘self-fulfilling prophecy’, as speculators follow the mood of other traders in the market, so that a frenzy of buying drives up the price further. Speculative ‘bubbles’ eventually burst, as market sentiment suddenly changes as traders realise that the price is unrealistically high and unsustainable. This results in a collapse in prices.

The housing and stock markets are also susceptible to speculative bubbles, with negative consequences for individuals and the wider economy. A collapse of house prices or share prices reduces household wealth and is likely to result in reduced spending and higher saving, as households try to restore the value of their savings (ie their wealth). This can lead to a recession. A collapse in the housing market can also trigger a banking crisis as banks are the major providers of mortgages (loans to buy houses).

Market rigging – Collusion amongst traders or financial institutions can lead to higher profits at the expense of others. For instance, banks may attempt to operate an interest rate cartel, so that interest rates to savers are lower, and to borrowers higher than would be the case in a more competitive market.

Another form of market rigging is insider trading. This is where individuals with privileged information use it to make a profit at the expense of others who do not have access to the information. For instance, if a company director knows that his firm is going to announce a big fall in profits s/he may sell them before the price falls, creating a disadvantage to the buyer.

Explain why speculation and market rigging in financial markets are examples of market failure.: Your answer should include: herding / speculative bubbles / recession / self-fulfilling prophecy / collusion / insider trading