Financial market failure and regulation

Question 1

what are the types of financial market failure?

Answer 1

• moral hazard
• asymmetric information
• negative externalities
• speculative bubbles
• market rigging

Question 2

how is asymmetric information and moral hazard a form of financial market failure?

Answer 2

• banks know that if they fail, the central bank will be there to bail them out, so they are more likely to take risks
• the central bank is unaware of this, so there is asymmetric information

Question 3

how are speculative bubbles a form of financial market failure?

Answer 3

• people take out loans to buy assets, so that they can then sell them for a higher price and make a profit
• people hugely overestimate the value of the asset and set a price that is too high, forming a speculative bubble
• people demanding the asset then realise that it isn’t worth this much and demand falls
• as demand falls people want to get rid of their assets and so they lower prices further
• as a result people now have worthless assets and loans that they cannot pay back because they made no profit

Question 4

how is market rigging a form of financial market failure?

Answer 4

• banks collude to manipulate markets and make high profits
• for example, the LIBOR rate was rigged (the interbank lending rate)

Question 5

give 2 regulators of financial markets

Answer 5

FCA - financial conduct authority
FPC - financial policy committee

Question 6

how does the FPC regulate financial markets?

Answer 6

• monitor and predict against systemic risk
• advice the government
• aim for financial stability

Question 7

how does the FCA regulate financial markets?

Answer 7

• regulates against market rigging
• promotes competition
• protects consumers