Financial Sector Flashcards
(22 cards)
What are the roles of financial markets?
To provide forward markets in currencies and commodities
To lend to businesses and individuals
To facilitate the exchange of goods and services
To provide a market for equities
To facilitate saving
FLEES
What are the different types of market failure?
Market rigging
Externalities
Asymmetric information
Moral hazard
Speculation and market bubbles
MEAMS
Define market rigging
Groups of individuals or institutions collude to fix prices or exchange information that will lead to gains for themselves at the expense of others
Market rigging is likely in financial markets as it is difficult to detect and participants have generally suffered very small penalties if caught
Give two examples of market rigging
Insider trading: The process of gaining advantage in market dealings due to having inside knowledge that isn’t available to the public (asymmetric information)
LIBOR scandal: LIBOR is the rate at which banks lend to each other, it has a wide impact in influencing other market rates of interest. Some banks (notably Barclays) falsely declared their rates which distorted the LIBOR rate and provided a gain for the business
Define moral hazard
When someone increase their exposure to risk when insured (a person takes more risks because someone else bears the costs of those risks)
Explain moral hazard in terms of financial incentives
Pay incentives in financial institutions tend to reward short-term rather than long-term performance
A worker gains the benefits of short-term gains through bonuses, but does not bear the long-term risks of those investments going bad
The worker is therefore incentivised to take more risk through their pay structure, knowing that any financial losses will be borne by the bank
Explain moral hazard in terms of ‘too big to fail’
Banks took too many short term risks, knowing that if things went wrong, they would be bailed out by government
The financial crisis of 2008 can be put down in large part to moral hazard
Define speculation and market bubbles
A market bubble is when the price of an asset is driven up to an excessive high and then collapses
The price becomes higher than the ‘actual’ value of the asset
The difficulty is that it is hard to spot a bubble until after it has burst
Give two examples of speculation and market bubbles
‘Dot com’ bubble 1999-2000
Housing market bubble 2000-2008
Describe the ‘Dot com’ bubble 1999-2000
Speculative ‘fad-based’ investing
Investors poured money into Internet startups during the 1990s in the hope that those companies would one day become profitable
Describe the housing market bubble 2000-2008
Very low interest rates, lax regulation and unsound lending led to over-lending in the US housing market
Once over-priced houses started to fall in value and interest rates started to rise, many borrowers defaulted on their ‘sub-prime’ mortgages
Define externalities
An externality is a cost or benefit incurred by a third party
Explain how externalities were involved in the financial crisis
The negative consequences of banks actions created an external cost borne by individuals and governments
Bank bailouts, as a result of poor financial management, cost over £2,000 per person in the UK
The impact of the financial crises also created external costs in the form of unemployment
Those unemployed for cyclical reasons in the years following the financial crisis, were paying the price for poor financial management by banks
Define asymmetric information
Banks may have more information than consumers
Give two examples of asymmetric information in banking
Payment Protection Insurance (PPI) mis-selling
Consumers did not understand what they were being sold, so many consumers purchased insurance that was unnecessary
Pensions mis-selling
Similar to PPI - consumers were sold pensions and left their much better ‘occupational schemes’
Describe policies that could correct market rigging
Primarily involves legislation & regulation of markets
Those found to conduct insider trading will face fines and prison
Evaluate the policies to correct market rigging
In reality, it can be very difficult to detect insider trading
Additionally, even when suspected it is very difficult to prosecute individuals
Describe policies that could correct moral hazard
Pre-emptive solutions to change the risk taking behaviour
- Separation of retail banking and investment banking: this would allow failing investment banks to close without contaminating the retail sector
- Regulation of banking behaviour, e.g. ensuring banks are not over-exposed to risky products
Why might it be difficult to correct moral hazard?
After the event - bailing banks out could be necessary to prevent a larger economic crash, but it creates a precedent that might reinforce the moral hazard in the banking sector
Describe policies that could correct market bubbles
In reality there is little to no way of pre-emptively regulating against market bubbles
Regulation of financial firms to ensure that they have enough liquidity (cash) and a diverse range of risk exposure should help to limit the impact of any crash in asset prices
Describe policies that could correct externalities
The problem is overly risky behaviour, so the main solution is regulation to ensure that banks are not overly exposed to risk
Following the 2008 financial crisis the financial regulation in the UK was completely overhauled in an attempt to be more effective
Once a crisis/recession has taken place the government might respond through expansionary demand-side policies
Low interest rates, quantitative easing and fiscal stimulus were all used in response to the financial crisis
Describe policies to correct asymmetric information
Significant fines have been used in recent years, along with forcing banks to compensate mis-sold customers to prevent the abuse of power by banks that might lead to mis-selling of financial products
