Financial Market Failure, the 2007-08 Crisis and Regulation
Financial market failure occurs when financial markets fail to allocate funds efficiently or fail to price risk correctly, leading to outcomes that damage the wider economy.
Before you start
Make sure you're comfortable with these topics first:
Method
- Learn each cause of financial market failure separately, asymmetric information, moral hazard, speculation and bubbles, externalities and systemic risk, and be ready to identify which one a scenario illustrates.
- Learn the outline of the 2007-08 crisis as a case study: risky, 'sub-prime', mortgage lending in the US, bundled into complex securities and sold on to investors globally, a housing market downturn triggering defaults, and a resulting credit crunch as banks became unwilling to lend to each other or to firms and households.
- Learn the macroeconomic consequences of a financial crisis of this kind: a sharp contraction in AD as consumption and investment fall, rising unemployment, and governments and central banks intervening with bank bailouts, interest rate cuts and quantitative easing.
- Learn the main forms of financial regulation used to reduce the risk of future crises: minimum capital requirements, requiring banks to hold a buffer of their own capital against losses; liquidity requirements, holding enough easily-sellable assets to meet short-term demands for cash; and stress testing, assessing whether a bank could survive a severe hypothetical downturn.
- Learn the role of a central bank as lender of last resort, providing emergency funding to solvent-but-illiquid banks to prevent a bank run from spreading through the system.
- Explain the AD/AS effect of a financial crisis: a leftward shift of AD from falling C and I, and, if it triggers a wave of business failures, a possible leftward shift of LRAS too, if productive capacity is permanently lost.
- Evaluate financial regulation on its trade-offs: tighter regulation reduces the risk of another crisis but raises the cost of borrowing or reduces the availability of credit, which can itself slow growth and investment.
Worked example
Explain, using an AD/AS diagram, how a banking crisis that causes a sharp fall in bank lending is likely to affect a country's real output and price level in the short run.
- A banking crisis that makes banks unwilling or unable to lend, a credit crunch, reduces the funds available to firms for investment and to households for large purchases.
- Since consumption (C) and investment (I) are both components of AD, a fall in lending reduces both, so AD falls, shifting the AD curve leftward, from AD1 to AD2.
- At the new intersection with SRAS, the price level falls, or its rate of increase slows, since firms face weaker demand for their output.
- Real output also falls, from Y1 to Y2, as the fall in spending reduces the quantity of goods and services firms are able to sell.
- If the fall in output leads to a sustained rise in unemployment or business closures, this can also start to reduce the economy's productive capacity, potentially shifting LRAS leftward too, a more damaging, longer-lasting effect.
Practice questions
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Q1What is meant by moral hazard in the context of banking?Show answer
Answer: A situation in which a bank takes on excessive risk because it does not expect to bear the full cost of failure, for example if it expects a government bailout if things go wrong.
Q2Briefly explain what happened in the US sub-prime mortgage market that helped trigger the 2007-08 financial crisis.Show answer
Answer: Banks lent heavily to borrowers with a high risk of default; when many of these borrowers defaulted, the value of mortgage-backed securities built on these loans collapsed, causing large losses across the global financial system.
Q3What is a credit crunch?Show answer
Answer: A sharp reduction in the availability of credit and lending, as banks become unwilling or unable to lend to each other, to firms, or to households.
Q4State one form of financial regulation introduced to make banks more resilient to future crises.Show answer
Answer: Minimum capital requirements, which require banks to hold a buffer of their own capital to absorb losses, or minimum liquidity requirements.
Q5What does it mean to describe a central bank as a lender of last resort?Show answer
Answer: The central bank will provide emergency funds to a solvent bank facing a short-term liquidity problem, to prevent a loss of confidence spreading into a wider bank run.
Q6Give one macroeconomic consequence of the 2007-08 financial crisis for the UK economy.Show answer
Answer: A sharp recession and a significant rise in unemployment, or a large rise in government borrowing as tax revenue fell and bailout and stimulus spending rose.
Q7State one cost of imposing stricter capital requirements on banks.Show answer
Answer: Banks may respond by lending less or charging higher interest rates to maintain their required capital ratio, which can reduce the availability of credit and slow investment or growth.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two causes of financial market failure that contributed to the 2007-08 global financial crisis.
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Evaluate the case for stricter regulation of financial markets to prevent a repeat of a crisis on the scale of 2007-08.
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