4.4.2 - Market failure in the financial sector
Financial markets help households save, firms borrow, and payments move through the economy. That importance is exactly why their failures are so serious. When finance goes wrong, the damage does not stay inside the banking sector: confidence falls, credit tightens, asset prices can collapse, and the real economy can be pulled into recession.
Information Failures
Financial products are often complex, so buyers do not always understand what they are taking on. That creates information problems which can stop markets from allocating resources efficiently.
Definition: Asymmetric information
When one party in a transaction has more or better information than the other.
In financial markets, institutions often know far more than their customers. That means a bank or intermediary may sell a product the customer does not really need, sell a product that is available more cheaply elsewhere, or sell a product that is much riskier than the buyer realises. UK payment protection insurance (PPI) is a clear case of the first: it was sold alongside millions of loans and credit cards, often to people who could never have claimed on it, and banks later paid tens of billions of pounds in compensation. In each case, the customer is not making a fully informed choice, so the market outcome is less efficient than it appears.
The 2008 financial crisis gave a clear example. Mortgage-backed products such as Collateralised Debt Obligations (CDOs) bundled together safer prime mortgages with much riskier subprime mortgages, and credit rating agencies gave many of them top AAA ratings. Many buyers, including other financial institutions and pension funds, did not understand the true risk profile. If they had known how exposed those assets were to default, many would not have bought them at the prices they did.
Asymmetric information also exists between financial institutions and regulators. Banks have little incentive to make every risky practice easy to understand, especially when profits depend on staying ahead of the rules. That means regulators can end up allowing dangerous behaviour to continue, regulation can be stuck playing catch-up with financial innovation, and product complexity can partly serve to hide rather than clarify risk.
Exam tip
A common consequence of asymmetric information is adverse selection. If lenders cannot distinguish safe borrowers from risky borrowers, they may charge higher interest rates or ration credit. That can drive safer borrowers out of the market first and leave a riskier pool behind, so lending becomes less efficient.
External Costs and Moral Hazard
Financial market failure matters because the costs spill well beyond the original borrower and lender. These spillover costs are negative externalities. If a major bank collapses, taxpayers may end up funding support packages, while households and firms that had nothing to do with the risky decision still face the consequences.
The UK experience in 2007-09 shows the scale of this problem. Northern Rock had to be nationalised, while RBS and Lloyds received major state support. The direct fiscal cost is only part of the story. A banking crisis also tends to reduce aggregate demand because lending contracts, firms cancel investment, households cut spending, unemployment rises, growth weakens, and public finances deteriorate as tax revenues fall and welfare spending rises.
Exam tip
The key extra idea is systemic risk. An isolated failure at one firm is serious, but finance is especially dangerous because banks and markets are interconnected through lending, payments, and asset holdings. That means one institution's failure can spread quickly to the rest of the system.
That means the social cost of excessive risk-taking is greater than the private cost faced by the institution making the decision. A bank may focus on the profits from a risky strategy while giving too little weight to the wider damage if the strategy fails. This is one reason risky behaviour can exceed the socially desirable level.
Exam tip
Do not confuse liquidity with solvency. A liquidity problem means a bank lacks cash or liquid funds right now, even though its assets may still exceed its liabilities. A solvency problem is deeper: the bank's assets are not worth enough to cover what it owes. Emergency central-bank lending can relieve a liquidity crisis, but it does not solve genuine insolvency on its own.
Definition: Moral hazard
When an individual or institution takes greater risks because someone else is likely to bear some of the cost if things go wrong.
Moral hazard appears in at least two important ways in finance. First, employees may be rewarded for short-run gains but not bear equivalent losses. A trader or mortgage salesperson whose bonus depends on volume or profit may take aggressive risks because the upside is personal, while the downside is largely borne by the firm. Second, large institutions may expect support from the central bank as lender of last resort or from government because they are seen as too big to fail. If rescue is expected, banks have a weaker incentive to avoid dangerous lending or highly leveraged trading. Profits are privatised, but part of the loss is socialised.
Exam tip
Keep adverse selection and moral hazard separate. Adverse selection is a pre-contract problem caused by hidden information, for example when lenders cannot easily distinguish safer from riskier borrowers. Moral hazard is a post-contract problem caused by changed behaviour, for example when protection from failure encourages banks or borrowers to take greater risks after the deal is made.
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