Financial market failures

Like other markets, financial markets can fail in several ways. Market failure is defined as a situation where markets do not allocate scarce resources efficiency. Financial markets are not immune from such failures.

A series of failures led to the financial crisis and not only affected banks, mortgage brokers, securitisers, credit rating agencies, and asset managers, but also had wide-ranging effects across the global economy.

Types of financial market failure

Asymmetric information

Financial transactions may result in inefficiencies when one party has more information than another party.

Potential information failure in financial markets can arise in almost all financial transactions.

While financial contracts are as detailed at they can be to encourage maximum transparency, there is still a significant reliance on trust (good faith).

Examples of information failure:

  1. Borrowers may not reveal their previous borrowing history.
  2. Lenders may not clarify the all the details and clauses attached to a loan.
  3. Sellers of financial contracts may put undue pressure on buyers – as was revealed in the pensions mis-selling scandal’ in the UK during the early 2000s. The principal-agent problem sheds light on why pensions were mis-sold. The agent who sold the pension may have an interest in not revealing details of the pension to the principal - the customer - because this may have meant that they missed their sales targets.
  4. The evolution of complex financial products through a process called securitisation – where debts were bundled into packages, and then resold – partly led to the sub-prime housing market collapse in the US in 2007. Mortgage debt was repackaged in such a way that banks were adding debt to their balance sheets but were unable to fully assess the risks associated with this debt. Banks simply took on too much risk in the search for profits. This compromised the bank’s need for an effective balance between profits and liquidity.

Moral hazard

Similarly, financial institutions prior to the financial crash were of the view that governments and central banks – as lenders of last resort - would cover any shortfall and deficiencies in their capital levels (capital adequacy), and ‘bail them out’. Of course, this creates a significant moral hazard as many banks thought they were simply ‘too big to fail’.

If borrowers believe that lenders will reschedule their debts, or simply write them off, there is an incentive not to act efficiently and make poor choices regarding how they use their loans, or how they operate their business or financial affairs. This is one of the reasons why credit markets in developing economies are less effective and charge high interest rates to cover the relatively high risk of defaulting on loans.

Adverse selection

Adverse selection is also a possible financial market failure and is defined as making inefficient or irrational decisions as a result of inadequate information. For example, good quality borrowers may be rejected for loans because there is insufficient information about their creditworthiness.

In the financial crisis, many banks engaged in ‘liquidity hoarding’ because they assumed that lending would result in a bad outcome for the bank. [1]

In order to resolve some of the problems of adverse selection banks may raise interest rates in the hope that returns from good quality borrowers will cover the losses from poor quality borrowers. Of course, this penalises good quality borrowers who may simply withdraw from the market. Over time only poor quality borrowers are left, and the financial market itself becomes a ‘lemons’ market. [i]

Externalities

In terms of financial market externalities, such externalities arise when there is a cost incurred that it not paid for by those directly engaged in the transaction. The activities of banks have a much wider effect on the economy than those directly involved in a financial transaction.

For example, when a bank fails it can result in considerable negative spill over effects across the whole economy, including job losses, bank bailouts, and the opportunity cost of using public funds to prop-up failing banks.

There may also be reputational damage to the financial sector as a whole with a ‘flight from money’ as individuals withdraw from the financial market altogether.

In developing economies, individuals may prefer to keep their savings at home rather than lend to banks, thus depriving the economy of a valuable flow of funds. The effect of bank problems can be exacerbated by how information – both good and bad – gets amplified throughout the banking system.

Creditor panic has been identified as a particular problem affecting financial markets, and minor issues with defaulting on debts can be amplified into significant reactions.

Speculation and market bubbles

Excessive speculation is also regarded as a market failure as it can result in extreme price changes in financial assets. The market for financial assets does not work in quite the same way as the market for other goods and services. Typically, demand for goods and service is inversely related to price, so that the demand curve for these goods slopes downwards.

However, when demand has a speculative element to it, as in the case of financial assets, price signals can operate ‘in reverse’. For example, when the price of shares increases speculators may purchase more in the expectation that the price will continue to rise. They can then hold the asset until they believe that the price will stop rising, or because they decide to sell in order to purchase a share that is rising at an even faster rate.

A ‘bull’ market is one where speculators are buying in the expectation of further price rises, whereas a ‘bear’ market is one where speculators sell assets in the hope of avoiding losses. The collective decisions of speculators can become self-fulfilling, and if sufficient numbers of them believe that the price will rise (or fall) their actions will cause the price to move as predicted. If sufficient speculators have a strong view about movements in future prices this can lead to a speculative bubble.

Speculative bubbles are reasonably common, but often the effect becomes extreme, and can result in much wider turbulence across the real economy, causing bankruptcies, falling output and job losses.

Irrational behaviour

Back in the late 1990s former US Federal Reserve Chair, Alan Greenspan, referred to the extreme behaviour of speculators as irrational exuberance, echoing Keynes earlier reference to ‘animal spirits’, which can drive up asset prices well above their ‘true’ level.

The phenomenon is also referred to as the ‘herd mentality’, bandwagon effect, and fomo (fear of missing out). It is this that turns a simple ‘bull’ market into a full-blown bubble. Bubbles can be sustained by financial institutions when they make loans to speculators which are then used to purchase more assets and drive the prices even higher.

Of course, the bubble will eventually burst, causing damage across the real economy. [2]

Market rigging

In an attempt to reduce risk traders in financial assets may collude and attempt to ‘rig’ the market in their favour.

Banks tend to operate under conditions of oligopoly, with just a few close competitors, which makes collusion to fix market conditions beneficial, and easy to coordinate. For example, interest rates can be set through tacit collusion, where one party operates as the leader and others are followers. This may be based on an implicit ‘rule’ rather than on any overt price rigging.

For example, if there are four banks in a market, A, B, C and D, and one of them, say bank B may historically be the ‘first mover’ in making a decision about interest rates changes (or any other aspect of banking business, such as opening hours). Bank B may be the oldest, largest, best managed or the most recognised brand, but whatever the reason, the other three banks will follow what move bank B makes.

Therefore, competition between the banks is reduced or eliminated, although it is still possible for them to compete in other areas - which may well keep the relevant regulator 'at bay'.

The LIBOR scandal

Sometimes, collusion can be more than just tacit, as in the case of the LIBOR scandal. The LIBOR rate (London Interbank Offered Rate) is a key global interest rate used to set rates on a wide array of loans to individuals, companies and governments.

Members of the scheme were supposed to submit interest rates which reflected their true position, and from this an average rate would be determined. However, it came to light in 2012 that banks were fixing these rates above or below the ‘true’ rate in order to support whatever ‘position’ their bank had taken. Rate fixing is likely to have taken place since 2003.

This type of behaviour is clearly anti-competitive and if discovered is likely to be investigated by the appropriate bank regulator, as in the case of LIBOR.

Many criminal convictions followed the LIBOR scandal, and responsibility for LIBOR was taken away from the British Bankers Association by the UK’s banking regulator, the Financial Conduct Authority (FCA), and given to a new organisation, the ICE (Intercontinental Exchange) Benchmark Administration (IBA), an independent UK subsidiary of the private U.S.-based exchange operator. [3]

A further failure revolves around the phenomenon of insider dealing, where knowledge which perhaps should have been made public is withheld (possibly for only a very short period of time) to enable insiders to exploit their superior knowledge. This could result from information relating to profit reports or to a likely bank acquisition being available to just a few insiders, before news goes public.

Of course, the financial crisis was an opportunity for banks to overhaul how they operate and for regulators to improve bank regulation to avoid such costly failures in the future.

Notes and sources

[1] Adverse Selection and Financial Crises Koralai Kirabaeva, 2011 Financial Markets Department, Bank of Canada

[2] Anna-Louise Jackson, John Schmidt Contributor, Editor 2021, https://www.forbes.com/advisor/investing/stock-market-bubble/

[3] CFR - https://www.cfr.org/backgrounder/understanding-libor-scandal

[i] after George Akerlof's analysis of the US second-hand car market.