Market Failure in the Financial Sector (Edexcel A Level Economics A)

Revision Note

Steve Vorster

Written by: Steve Vorster

Reviewed by: Jenna Quinn

Market Failure in the Financial Sector

  • Market failure in financial markets has far reaching consequences. The Global Financial Crisis of 2008 highlighted the interdependence and fragility of the global financial system

Types of Market Failure in Financial Markets

Market Failure

Explanation

Asymmetric information

  • Many financial products are complex and 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 and 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 and the regulators set up to monitor them

Externalities

  • Negative externalities of production and 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' and 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 and 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 and market bubbles

  • The higher the money supply in an economy, the greater the speculation and potential for market bubbles

    • Significant amounts of quantitative easing since 2008 have increased the money supply and created potential bubbles in different markets (e.g. property, cryptocurrency, shares)

Market rigging

  • There have been allegations that some banks and 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

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Steve Vorster

Author: Steve Vorster

Expertise: Economics & Business Subject Lead

Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.

Jenna Quinn

Author: Jenna Quinn

Expertise: Head of New Subjects

Jenna studied at Cardiff University before training to become a science teacher at the University of Bath specialising in Biology (although she loves teaching all three sciences at GCSE level!). Teaching is her passion, and with 10 years experience teaching across a wide range of specifications – from GCSE and A Level Biology in the UK to IGCSE and IB Biology internationally – she knows what is required to pass those Biology exams.