Financial Markets & Market Failure
Financial Markets & Market Failure
Financial markets channel funds from savers to borrowers, enabling investment, consumption, and economic growth. Understanding their functions, structures, and the market failures they create is essential for A-Level Economics.
Functions of Financial Markets
1. Facilitating Saving
- Financial institutions (banks, building societies) offer savings products (current accounts, ISAs, bonds)
- Provide a return on savings (interest) → incentivise deferred consumption
- Pool small savings into large investment funds
2. Lending to Businesses and Individuals
- Banks channel savings into loans for firms (investment) and households (mortgages, consumer credit)
- Maturity transformation: banks borrow short (demand deposits) and lend long (mortgages) — creates liquidity but also risk
3. Facilitating Exchange of Goods and Services
- Payment systems (debit cards, bank transfers, digital payments) enable transactions
- Foreign exchange markets enable international trade
4. Providing Forward Markets in Currencies and Commodities
- Derivatives (futures, options, swaps) allow firms to hedge against price and exchange rate risk
- An airline can lock in fuel prices; an exporter can fix the exchange rate
- Reduces uncertainty → encourages trade and investment
5. Providing a Market for Equities (Shares)
- Stock markets (London Stock Exchange) enable firms to raise capital by selling shares
- Provide liquidity: shareholders can sell shares to other investors
- Share prices aggregate information about expected future profits → price discovery
Types of Financial Markets
| Market | Function |
|---|---|
| Money market | Short-term lending/borrowing (< 1 year) — Treasury bills, commercial paper, interbank lending |
| Capital market | Long-term finance — shares (equities) and bonds (corporate and government) |
| Foreign exchange (forex) | Currency trading — world's largest market (~$7.5 trillion daily turnover) |
| Derivatives market | Futures, options, swaps — hedging and speculation |
| Insurance market | Transfer of risk — premiums paid for protection against loss |
The Role of Financial Markets in the Economy
The Loanable Funds Market
- Supply: savings by households, firms, and government
- Demand: borrowing for investment, government spending, consumer credit
- Interest rate: the price that equilibrates supply and demand for loanable funds
- Higher interest rates → more saving, less borrowing → lower investment
Credit Creation by Banks
Banks create money through the fractional reserve system:
1. A deposit of £1,000 is made
2. The bank keeps a fraction as reserves (say 10% = £100) and lends £900
3. The £900 is spent and deposited in another bank
4. That bank keeps £90 and lends £810
5. Process continues — money multiplier = 1 / reserve ratio = 10
Total money created from the initial £1,000 deposit = £10,000
In practice, the money multiplier is constrained by:
- Regulatory capital requirements (Basel III)
- Banks' willingness to lend (risk appetite)
- Borrowers' willingness to borrow (confidence)
- Central bank policy (Bank Rate, reserve requirements)
Market Failure in Financial Markets
1. Asymmetric Information
Adverse selection (before the transaction):
- Borrowers know more about their creditworthiness than lenders
- High-risk borrowers are more eager to borrow → lenders cannot distinguish risk → may charge all borrowers higher rates → good borrowers leave → market quality deteriorates
- Example: sub-prime mortgage crisis — loans given to borrowers who could not afford them
Moral hazard (after the transaction):
- Once a loan is made, the borrower may take excessive risk (the lender bears the downside)
- Bank managers take excessive risk knowing bailouts are likely ("too big to fail")
- Insurance: once insured, people may take less care (car insurance and reckless driving)
2. Externalities
Systemic risk: the failure of one financial institution can cascade through the entire financial system:
- Banks are interconnected through interbank lending
- A bank failure causes contagion — other banks lose confidence, withdraw lending
- Credit markets freeze → firms cannot borrow → output falls → recession
- This is a massive negative externality — the failing bank does not bear the full social cost
- 2008 example: Lehman Brothers' collapse triggered a global financial crisis
3. Speculation and Bubbles
- Speculative bubbles: asset prices (shares, property) rise far above fundamental value, driven by herd behaviour and irrational exuberance
- When the bubble bursts: wealth destruction, banking losses, recession
- Examples: dot-com bubble (2000), US housing bubble (2007-08), tulip mania (1637)
- Hyman Minsky's Financial Instability Hypothesis: stability breeds complacency → excessive borrowing → fragility → crisis. "Stability is destabilising."
4. Market Power
- Large banks may have oligopolistic power → restrict competition → higher fees, lower savings rates, less innovation
- "Too big to fail" creates moral hazard — banks know they will be bailed out → take excessive risk
- Concentration in financial services has increased (top 5 UK banks hold ~80% of current accounts)
The 2008 Global Financial Crisis
Causes
1. Sub-prime mortgages: US banks lent to high-risk borrowers (low documentation, teaser rates)
2. Securitisation: mortgages were packaged into complex financial products (MBS, CDOs) and sold globally — risk was obscured and spread
3. Credit rating agencies gave AAA ratings to risky securities (conflict of interest — paid by issuers)
4. Excessive leverage: banks borrowed heavily relative to their capital (30:1 or more)
5. Deregulation: light-touch regulation allowed excessive risk-taking
6. Moral hazard: implicit government guarantee ("too big to fail") reduced incentive for caution
7. Herd behaviour and speculation: property prices were assumed to only rise
Consequences
- Global recession (2008-09): worst since the 1930s
- UK GDP fell 6.3%; unemployment rose to 2.7 million
- Government bailouts of RBS and Lloyds cost taxpayers ~£65bn
- Austerity measures (2010 onwards) to reduce the resulting fiscal deficit
- Quantitative easing: £375bn initially, eventually £895bn
- Long-term: lower productivity growth, wage stagnation, inequality
Policy Responses and Reforms
| Reform | Purpose |
|---|---|
| Basel III (2010) | Higher capital requirements, liquidity ratios, leverage limits for banks |
| Bank of England Financial Policy Committee (FPC) | Macroprudential regulation — monitors systemic risk |
| Stress testing | Banks must demonstrate they can survive economic shocks |
| Ring-fencing (2019, UK) | Separate retail banking from investment banking (Vickers Report) |
| Resolution mechanisms | Plans for orderly failure of banks without taxpayer bailouts |
| Regulation of derivatives | Central clearing of OTC derivatives to reduce counterparty risk |
Evaluation
Has regulation gone far enough?
- Banks are better capitalised and more closely supervised
- But shadow banking (non-bank financial institutions) remains lightly regulated
- Fintech creates new risks (cryptocurrency, algorithmic trading)
- Global coordination remains weak (regulatory arbitrage)
- "Too big to fail" problem persists — banks have grown even larger since 2008
Has regulation gone too far?
- Higher capital requirements may reduce lending (especially to SMEs)
- Compliance costs burden smaller banks → consolidation → less competition
- Over-regulation may push activity to less regulated jurisdictions
Exam Technique
- Explain the functions of financial markets clearly — do not just list them
- Use asymmetric information (adverse selection, moral hazard) as analytical tools
- The 2008 crisis is the key case study — know the causes, consequences, and policy responses
- Link financial market failure to AD/AS (credit crunch → AD falls → recession)
- Evaluate post-crisis regulation: has it been effective? Has it gone too far?
- Reference Minsky for financial instability and the cycle of stability → complacency → crisis