Edexcel A-Level Economics · Revision notes

4.4.2 Market failure in the financial sector

Financial markets are prone to market failure in ways that can damage the whole economy. The global financial crisis of 2007 to 2008 showed how failures in banking can turn into a deep recession, with costs falling on people who had nothing to do with the original decisions. This topic covers five sources of market failure in the financial sector.

Asymmetric information

Financial products are complex, and those who sell them usually understand them far better than those who buy them.

• Mis-selling. Customers may be sold products that are unsuitable or overpriced. In the UK, millions of people were sold payment protection insurance (PPI) they did not need or could not claim on, and banks later paid out billions of pounds in compensation.
• Hidden risks. Before the financial crisis, mortgages to borrowers who were unlikely to repay were bundled into complex securities and sold as low-risk investments. Buyers did not understand what they were buying.
• Lenders and borrowers. Borrowers know more about their ability to repay than lenders do, so lenders may lend to the wrong people or charge everyone more.

The result is that resources flow to the wrong uses and risks are taken that buyers would not have accepted with full information.

Externalities

When a bank fails, the costs spread far beyond its own shareholders and customers.

• Contagion. Banks lend to each other, so the failure of one can threaten others, spreading panic through the financial system.
• Effects on the wider economy. When banks stop lending, firms cannot invest and households cannot borrow, so spending falls and unemployment rises. The financial crisis led to a deep recession in the UK and many other countries.
• Costs to taxpayers. Governments may have to rescue failing banks with public money. In 2008, the UK government took large stakes in RBS and Lloyds.

Because banks do not bear these external costs, they take more risk than is socially optimal.

Moral hazard

Moral hazard occurs when someone takes more risk because they know they will not bear the full cost if things go wrong.

• If banks believe the government will rescue them because they are too big to fail, they have an incentive to take bigger risks: the profits go to the bank, but the losses may fall on taxpayers.
• Bankers paid large bonuses for short-term profits may take risks that pay off in the short run but cause losses later.

Evaluation: Rescuing banks can prevent a crisis, but it also strengthens the expectation of future rescues, making moral hazard worse.

Speculation and market bubbles

Speculation is buying an asset in the hope of selling it later at a higher price. When many people speculate at once, prices can rise far above any value justified by the asset's earnings. This is a bubble.

• Rising prices attract more buyers, who push prices higher still, until confidence breaks and prices collapse.
• The US housing bubble before 2007 and the boom in technology shares in the late 1990s are examples.

Key idea: When a bubble bursts, people who bought near the top suffer heavy losses, lenders face defaults, and the fall in wealth reduces spending across the economy. Bubbles misallocate resources by drawing investment into overvalued assets.

Market rigging

Market rigging is the deliberate, often illegal, manipulation of a financial market for private gain.

• The LIBOR scandal. LIBOR was a benchmark interest rate used to set the cost of loans and financial contracts worldwide. Traders at several banks were found to have manipulated it, and banks including Barclays were fined heavily from 2012 onwards.
• Foreign exchange rigging. Traders at several major banks colluded to manipulate exchange rates, and the banks were fined in 2014.
• Insider trading, buying or selling shares using confidential information, is also a form of market abuse.

Rigging undermines trust in financial markets and means prices no longer reflect genuine supply and demand.

Responses

Governments and central banks have responded with:

• tighter regulation, such as requiring banks to hold more capital;
• separating everyday retail banking from riskier investment banking;
• stronger supervision by regulators such as the Financial Conduct Authority and the Prudential Regulation Authority;
• larger penalties for market abuse.

These are covered further in the topic on central banks.

Key terms

Common mistakes

• Confusing moral hazard with asymmetric information. Moral hazard is about behaviour changing because the risk is borne by someone else.
• Describing events without the market failure. Each example needs a link to a misallocation of resources or costs on third parties.
• Treating all speculation as harmful. Speculation can help markets work; the problem is bubbles that become detached from underlying value.
• Forgetting the wider economy. The key externality is the effect of banking failure on output and employment.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in two formats:

• 4-mark "Explain" data response — asked once (2024)
• 1-mark multiple choice — asked once (2022)

Where this goes next

The normal roles of financial markets are covered in 4.4.1 Role of financial markets, and the central bank's role in regulation and as lender of last resort in 4.4.3 Role of central banks. The general theory of these failures is in 1.3.2 Externalities and 1.3.4 Information gaps, and government intervention in 1.4.1 Government intervention in markets.