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level: Financial Market Failure

Questions and Answers List

level questions: Financial Market Failure

QuestionAnswer
When do Financial Crisis usually Happen?-The Ways that can Trigger a Financial Crisis is Myriad -But it usually Happens after a Long Period of Economic Prosperity as Interest Rates are Low, Credit is Abundant, Speculation is High, and Overconfident Markets. This leads to a Recession like 2008
How can Financial Crisis make a normal Recession more Harmful-Not only it takes Longer for the Economy to Recover, the Systematic Risk creeps back up again -One Bank acting faulty can lead to the Breakup of the Banking System and quickly Spread. Confidence and Spending can cease to Exist which can affect the International World
What does Speculation mean?-Refers to when Individuals try to make Profits by buying Assets quite Cheaply, and selling them at a High Price
What are Market Bubbles?-When the level of Speculation is High, then: -Investors will keep Expecting the Price to rise to Unrealistic Realms - like Internet Stocks in the Late 1990s -When the Confidence goes down, even by a bit, the Bubble can 'pop' and make the Prices of these Assets crash down. This can be a cause of a Financial Crisis.
Why can 2008 be an Example of a Market Bubble? What happened?-2008 saw a Speculative Bubble in the US Housing Market crashing down. The Growth in the 'Sub Prime' Mortgage Market (Risky Mortgage Lending) led to House Prices Rising -As they got more Expensive, people started to Default on their Mortgages as it got too Expensive -Eventually, in 2008, the Bubble had been too big and Popped, when too many people had Defaulted, leading to House Prices Crashing -Bank's Assets Sheet had reduced Severely and had to Cut Lending creating a Credit Crunch -This lent itself to a Loss in Confidence overall in the US and Europe, leading to a Deep Recession
What are the Negative Externalities that Financial Markets can Bring-The Mismanagement of Risk can be a Cause of an Externalities. 2008 saw Huge Taxpayers spent because of not Balancing Risk with Security -Large Drops in GDP, Falling Salaries and Unemployment Rising are other, Acute Externalities
What is the Idea behind the 'Too Big to Fail' saying?-The Bailout for Banks had been a Large Need for the Banking Industry, as their Size was too Big for the Economy. -If a Large Bank had Collapsed, the Panic and Fear would lead to an overall Meltdown in the Financial System -The UK, USA and Europe had to deploy Large Bailout Schemes in 2008, even if it costed Billions of $$$$$
Why can Asymmetrical Information find its way in the Financial Market?-When one Party has Less Information than the Other, then Asymmetrical Information Exists -Borrowers will know Better than Lenders how Likely they will Pay back a Loan
What is Adverse Selection?-This occurs when the Most Likely of Buyers of a Product are those that the Seller would Prefer NOT to sell to. -This leads to Firms making Unknowingly Riskier Decisions than that was Thought out
In an Insurance Markets, how can Adverse Selection affect it?-If a Firm engages with Medical Insurance, it will Calculate the Insurance Premiums (Cost of Obtaining the Policy_ based on People it will think will Buy it -The Premiums may be too High for the People that would want to Pay it - like Healthy People (who are Ideal) -But it would be good for Poor Health People, who will be a Drain on the Firm's Liabilities -The Insurance Firm will thus be making a more Unprofitable and Riskier Balance Sheet, which was Unexpected
What is the Idea behind Moral Hazard?-This refers to when an Individual engages with Riskier Behaviour as they know someone else will Pay for their Consequences -Banks may be more Risky, as they know the Government will Bail them out