Financial markets GapFill

The financial sector plays a crucial role in the macroeconomy, both globally and particularly in the UK. Flows of money associated with international trade, foreign currency exchange, the balance of payments and government expenditure, are all processed through the financial sector. In the UK, the City of London is home to both the commercial bank headquarters and the central bank: the Bank of England.

Market failure has become an important topic in relation to the financial sector following the 2007−08 financial crisis, which sparked a worldwide global recession. There are different types of market failure associated with the financial sector that it is important to distinguish between. Firstly,  moral hazardmarket riggingmarket bubblesasymmetric behaviour refers to banking regulation, and the idea that regulators may not be as well informed as those who work in the financial sector, and as a result may fail to notice or sufficiently restrict improper or excessively risky practices. 

Secondly,  asymmetric behaviourmarket riggingmarket bubblesmoral hazard refers to the experience of the banks being 'bailed out' by the government in 2007, when they were on the brink of collapse. Specifically, it is the idea that bankers may be incentivised to take excessive risks expecting that the government will step in to rescue them if such an event happens again. This is associated with the idea that the financial sector is 'too big to fail', in contrast to standard  moral hazardfree marketasymmetric behaviourmarket rigging orthodoxy which contends that industries succeed or fail based on their performance alone. 

Thirdly,  moral hazardmarket riggingasymmetric behaviourmarket bubbles refers to improper and/or illegal practices in which bankers have attempted to manipulate  market bubblesmarket riggingexchange ratesasymmetric behaviour or interest rates for personal financial gain.

Fourthly,  asymmetric behaviourmarket riggingmoral hazardmarket bubbles refers to the practice of investors, either knowingly or unknowingly, driving up the price of an asset significantly above its actual market value. This often results in a sudden crash when investors realise they have overspent and all seek to sell their investments at once. This was a key cause of the 2007−08 financial crisis as speculators realised their financial assets relating to overleveraged mortgages in the US were worth significantly less than the prices they had paid for them.

Finally,  market bubblesmarket riggingnegative externalitiesasymmetric behaviour as a result of financial practices should also be considered in the realm of market failure. These could be the environmental costs of focusing on short-term financial gains rather than long-term sustainable investments, or the social costs of the UK government's austerity programme, implemented in response to the government's bailout of commercial banks in 2008.