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

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

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 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

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)

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