Market Failure in the Financial Sector

Economics: Edexcel A A Level, topic 8.3.2

Moral Hazard

Moral hazard happens when people engage in riskier behaviour with insurance than they would without insurance.

Imperfect information is the cause of moral hazard.
If insurance companies had perfect information, they could simply add a premium every time a consumer engaged in risky behaviour. Technology is helping to do this in some areas e.g. car telemetry boxes.
But in a world of asymmetric information, this is not possible. So, moral hazard exists.

Moral hazard cannot be removed completely. But its effects can be reduced.
You could require the injured party to pay a share of the costs.
E.g insurance policy deductibles. This is an amount you must pay out of your own pocket before your insurance covers the fee.
You can also focus on the incentives of the providers rather than the consumers.

The financial sector does experience market failure. These problems include:

Moral hazard happens when people engage in riskier behaviour with insurance than they would without insurance.
In 2007-08, investment banks and insurance companies like AIG were 'Too big to fail'. If they collapsed, there was a risk that the global economy would also collapse. So governments bailed out these large banks and insurance companies.
Bailing out AIG cost the US government $182bn.

Lots of bad loans were made to people who couldn't afford to make their mortgage payments.
Banks lent these people the whole cost of the house plus 10% to 'do it up nicely'.
The individuals arguably had better information than the bank that they may not be able to repay these loans.
Insider trading, where people profit from non-public information, can also be individuals benefitting from asymmetric information.

Speculation can stop markets functioning correctly. In 2008, house prices rose so high that many could not afford to buy any more. However, lots of these purchases were made based on speculation. Speculative asset purchases can have negative externalities.
Hedge fund and asset managers can speculate on stocks, without creating any extra value for the people whose money they trade with. In exchange for speculating, they also take a 1% annual management fee. John Kay's 'Other People's Money' is very critical of this feature of speculation in financial markets.

Market rigging is when people in the market artificially fix or control prices.
Investment bankers like Tom Hayes of UBS, rigged the financial market for 'LIBOR'. He was sentenced to 14 years in prison for this offence.

Which of the following is an example of moral hazard?
Which of the following is an example of moral hazard?
What do we call it when people take more risk because they are protected by insurance?
What happens when people engage in riskier behaviour with insurance than they would without insurance?
How much did bailing out AIG cost the US government?