Financial Market Failure
- Financial markets can fail and misallocate resources, with costs for consumers, firms and taxpayers; the main sources are asymmetric information, moral hazard, externalities, speculation and market rigging.
Asymmetric Information and Moral Hazard
Definition
Asymmetric information: where one party to a transaction has more or better information than the other.
Adverse selection: where, before a contract, the riskier party is the one most likely to seek the deal.
Moral hazard: the tendency to take greater risks once protected from the consequences.
- Adverse selection arises before a contract: lenders cannot tell safe from risky borrowers, so risky borrowers crowd in and interest rates rise, pricing good borrowers out.
- Moral hazard arises after a contract: a bank that expects a government rescue may lend recklessly, so the cost of failure falls on taxpayers, as in the 2008 financial crisis.
Externalities and Contagion
Definition
Negative externality: a cost of a financial decision that falls on third parties who are not part of it.
- The failure of one large bank can spread contagion through the system, freezing lending and harming firms and households across the wider real economy.
Speculation, Bubbles and Rigging
Definition
Speculation: buying assets to profit from price changes rather than for their underlying use or income.
Market bubble: where speculation pushes an asset's price far above its fundamental value.
Market rigging: where firms collude or manipulate prices for their own gain, such as insider dealing or fixing benchmark interest rates.
- When confidence turns, a bubble bursts and the crash can spill into the real economy, as in the US subprime housing bubble that triggered the 2008 crisis.
- Market rigging distorts prices and erodes the trust that financial markets depend on, for example the LIBOR benchmark rate-fixing scandal.
Can regulation correct financial market failure?
- It holds because rules such as capital requirements, deposit insurance and conduct regulation can curb reckless risk-taking, limit contagion and punish rigging.
- But regulation is costly, can be evaded through financial innovation, and a bailout safety net can itself worsen moral hazard by protecting risk-takers.
- On balance it depends on the design and enforcement of the rules and on whether regulators keep pace with fast-changing markets.
Exam technique
- Define each source of failure and explain how it misallocates resources.
- Place adverse selection before a contract and moral hazard after it.
- Link financial market failure to spillovers into the real economy.
Common Mistake
- Do not confuse moral hazard with adverse selection, since moral hazard follows a contract while adverse selection precedes it.
- Do not treat a bubble price as a fair market price, because speculation can drive prices far above fundamentals.
Self review
- What is asymmetric information?
- Define moral hazard and give an example.
- How can financial decisions create externalities?
- What is a speculative bubble?
- What is market rigging?
