Financial market failures

Financial market failures refer to situations where financial markets fail to operate efficiently, causing lost economic output and reductions in the value of national wealth.

Failure of the price mechanism

When a financial market fails, it means that the price mechanism does not work effectively. A significant function of the price mechanism is to allocate goods and services a price, but in financial markets, the prices of assets may not reflect the full range of costs and benefits associated with owning, or trading in, those assets. For example, failing to establish the ‘risk’ associated with holding a financial asset may cause a divergence between the market (or traded) value of the asset, and the true value. This can distort decision making and lead to a misallocation of resources.

One feature of the financial crisis was the emergence of ‘toxic’ assets, where risks were hidden, and market values failed to reflect the underlying valuation of the asset if based on accurate risk calculation.

There are several features of financial markets that suggest that within those markets the price mechanism may fail maximise economic welfare.

Types of financial market failure

Asymmetries and information failure

The most significant market failure affecting financial markets is the failure to provide sufficient information to make rational choices about the value of an asset. Information failure may affect the buyer or seller, or both parties.

One feature of financial markets in the period preceding the financial crash was the emergence of new types of security, and hence new types of risk. Low interest rates and poor yields from ‘safe’ government bonds meant that global investors were looking for new assets to invest in. This demand triggered the expansion of securitised debt, where existing debts are packaged up and sold as new assets. This encouraged the introduction of new and innovative derivatives and other instruments, such as CDOs (collateralised debt obligations). However, this meant that holders of debt became increasingly unaware of the risks they were exposed to. Consequently, they remained ignorant of the possible impact on them (or their balance sheets) of individuals and organisations defaulting on their debts.

In the absence of information, risks tended to be under-estimated, and asset values over-estimated. This meant that many institutions made less than prudent decisions about the assets they held. This also encouraged them to lend to high risk, sub-prime, borrowers, such as those in the sub-prime housing market.

Moral hazard

The failure to understand the level of risk associated with securitised assets was compounded by the assumption by many financial institutions that they were ‘too big or too important’ to fail, and hence would be bailed out should the need arise. This encouraged further risk taking above and beyond a rational level. In this case, the central bank – in its role of lender of last resort – was seen as an ‘insurance policy’ should the financial institutions suffer excessive losses from imprudent lending.

The theory of moral hazard suggests that whenever individuals or organisations are insured against suffering from the losses associated with economic decisions, they will act with less regard to the negative impact of those decisions.

Excessive speculation

The demand for, and supply of, financial assets is governed largely by speculative motives – buy in anticipation of a capital gain, and sell to avoid a capital loss. Given the absence of full information about future values and risks, the behaviour of speculators is subject to what Keynes referred to as ‘animal spirits’ and the ‘herding instinct’. This means that markets can experience ‘bubbles’, with market values being driven up well beyond their ‘true’ value. Eventually, some speculators predict that the next movement in asset prices is downwards and, as a result, sell their assets to avoid a loss. This then triggers a fall in price as the ‘bubble bursts’, with the rest of the herd starting to sell.

It can be argued that while price movements are beneficial for a healthy financial market, excessive speculation creates excessive instability, and prevents financial markets from performing effectively.

Fall-out from externalities

Given the above failures, it is clear that, from time to time, financial markets can fail, either in a minor or temporary way – such as failing to provide sufficient liquidity – or in a way that creates significant macro-economic fall-out.

Financial market failures can lead to numerous negative externalities, which may include:

Falling real output.
Rising unemployment.
Falling real wages.
Rising poverty levels.
Falling profits and bankruptcies.

Lack of competition and market rigging

The relatively small number of financial institutions dominating particular financial markets may encourage market players to collude and undertake cartel-like behaviour. Collusive behaviour may extend to market ‘rigging’, where asset prices, or other aspects of the market, are fixed by the dominant firms.

This is what happened in the Libor scandal (Libor is the London Interbank Offered Rate) which involved fixing interest rates and exchange rates. A Libor rate is an average interest rate (or exchange rate) calculated through submissions by major global banks. In terms of interest rates, the Libor rate is then used globally to fix rates on a variety of loans – from mortgage rates to student loan rates.

Rate submissions are supposed to be based on actual bank data, but investigations in the USA showed that five major banks – Citicorp, JPMorgan Chase, Barclays, the Royal Bank of Scotland and UBS AG – colluded over a number of years to set exchange rates in their favour. Other investigations revealed widespread rate fixing across global financial markets.

Conclusion

The extent of these failures, and the severity of the global financial crisis, forced governments and central banks to rethink how they should supervise and regulate financial markets to reduce the impact of these failures and financial shocks.

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