4.4.2 Market failure in the financial sector

• Market failure occurs when resource allocation is inefficient
• Asymmetric information in financial markets means one party has more knowledge
• Moral hazard arises when financial institutions take excessive risks knowing they might be bailed out.
• Adverse selection in financial transactions occurs when lenders cannot distinguish between high-risk and low-risk borrowers
• What is the impact of externalities in financial activities?

  Affects third parties
• Systemic risk refers to the failure of a single financial institution affecting the entire system.
• Government interventions are necessary to correct market failures
• Match the cause of market failure with its description:

  Asymmetric information ↔️ One party has more knowledge than the other, leading to unfair transactions

  Moral hazard ↔️ Financial institutions take excessive risks knowing they might be bailed out

  Speculative bubbles ↔️ Rapid asset price increases unsustainable and prone to crashes

  Externalities ↔️ Costs or benefits affecting third parties not involved in transactions
• Steps in asymmetric information scenarios:

  1️⃣ Adverse selection: Before a transaction, one party knows more about the quality of the financial product

  2️⃣ Moral hazard: After a transaction, one party changes its behavior due to lack of oversight
• When does market failure occur in the financial sector?

  Inefficient resource allocation
• Moral hazard encourages financial institutions to take excessive risks.
• Market failure in the financial sector results in the failure to produce socially optimal levels of output
• Match the cause of market failure with its description:

  Asymmetric information ↔️ One party has more knowledge than the other, leading to unfair transactions

  Moral hazard ↔️ Financial institutions take excessive risks knowing they might be bailed out

  Speculative bubbles ↔️ Rapid asset price increases unsustainable and prone to crashes

  Externalities ↔️ Costs or benefits affecting third parties not involved in transactions
• The 2008 financial crisis highlighted the consequences of moral hazard
• What is the effect of adverse selection on financial markets?

  Inefficient market outcomes
• Regulations such as mandatory risk assessments help mitigate adverse selection
• What is an example of moral hazard in financial markets?

  Borrowers misusing loan funds
• What are the two types of asymmetric information in financial markets?

  Adverse selection, Moral hazard
• Adverse selection occurs before a transaction.
• Moral hazard arises when borrowers change behavior after receiving a loan due to less oversight.
• Match the type of asymmetric information with its timing:

  Adverse selection ↔️ Before transaction

  Moral hazard ↔️ After transaction
• Why does moral hazard occur in financial institutions?

  Lack of consequences
• Bailouts for financial institutions are funded by taxpayers.
• The 2008 financial crisis encouraged risk-taking behavior due to government bailouts.
• Order the key aspects of moral hazard based on their sequence:

  1️⃣ Increased risky investments

  2️⃣ Higher financial crises likelihood

  3️⃣ Taxpayer costs
• What is the primary consequence of moral hazard in the financial system?

  Substantial economic consequences
• Regulations such as mandatory risk assessments help mitigate adverse selection.
• What are negative externalities in the financial sector?

  Costs to third parties
• Bank failures are an example of negative externalities in the financial sector.
• Match the level of systemic risk with its economic impact:

  High systemic risk ↔️ Disruption, volatility, bailouts

  Low systemic risk ↔️ Stability, growth
• What is the purpose of government interventions in financial markets?

  Correct market failures
• Taxes on speculative transactions aim to reduce risky behavior.
• The Dodd-Frank Act in the US is an example of regulation aimed at preventing systemic risk.
• What is the effect of excessive risk-taking by banks on the economy?

  Systemic instability
• Match the cause of market failure with its description:

  Asymmetric information ↔️ One party has more knowledge

  Moral hazard ↔️ Financial institutions take excessive risks

  Externalities ↔️ Costs or benefits affecting third parties

  Speculative bubbles ↔️ Rapid and unsustainable asset price increases
• The financial sector can experience market failures due to various factors
• What is the term for a situation where one party has more knowledge than the other in a transaction?

  Asymmetric information
• Financial institutions taking excessive risks knowing they might be bailed out is known as moral hazard.
• What is the term for rapid and unsustainable increases in asset prices?

  Speculative bubbles
• Regulatory interventions are necessary to ensure stability and fairness in the financial sector.