4.4.2 Market failure in the financial sector Quiz: Pearson Edexcel Economics A, Unit 4

The 20 questions

1. What is asymmetric information in financial markets?

   • A situation in which all parties have exactly the same information, so that no risk ever arises in lending or investing
   • A situation in which share prices are set by a central authority, so that no buyer or seller has any information at all
   • A situation in which one party to a transaction has better information than the other, for example about a borrower's risk
   • A situation in which information is published by governments only, so that private investors never see it in any market

2. How can asymmetric information cause a market failure in banking?

   • Borrowers always know the exact future returns on their projects, so banks can always set the correct rate for each loan
   • Lenders always have perfect information, so they never lend to risky borrowers and no failure of any kind occurs
   • Lenders may be unable to judge borrowers' risk, so they may lend too much to risky borrowers or too little to safe ones
   • Asymmetric information ensures that interest rates are always set at the same level for all borrowers in every market

3. What is moral hazard in the financial sector?

   • When a borrower repays a loan early, which reduces the interest income that the lender expects to receive
   • When a bank is caught lying about its accounts, which is always a criminal offence under all financial law
   • When a party takes on more risk because someone else will bear the cost if things go wrong, such as a bailout
   • When a party refuses to take any risk at all, because it fears losing money in every transaction it makes

4. How might government bailouts of banks create moral hazard?

   • Bailouts always lead to banks being nationalised permanently, which removes their incentive to lend to any firm at all
   • Banks may expect rescue if they fail, which can encourage them to take greater risks in their lending
   • Bailouts make banks more cautious, since they fear losing government support and so reduce their lending to all customers
   • Bailouts have no effect on bank behaviour, because banks never consider government support when they take decisions

5. What is an externality in a financial market?

   • A transaction in which both buyer and seller are always fully aware of all costs, so no third party is affected
   • A financial asset that is traded only on foreign stock exchanges, which avoids all domestic regulation and tax
   • A cost or benefit imposed on third parties not involved in a transaction, such as the spread of financial contagion
   • A payment made to a bank by a customer outside normal opening hours, which is recorded as a separate charge

6. Which is an example of a financial externality?

   • A household's deposit being earning interest for the household, which is a benefit that stays within that household
   • A firm paying a dividend to its own shareholders out of profits, which affects only those shareholders
   • A bank charging customers a fee for opening a new account, which is a cost borne only by the customer
   • The failure of one bank spreading losses to other banks and firms that were not party to its lending decisions

7. What is speculation in financial markets?

   • Buying assets only for their long-term income, with no intention of ever selling them for a gain in the market
   • Buying assets in the expectation of selling them later at a higher price, rather than for their use or income
   • Buying goods only for personal consumption, which has no effect on prices or on the wider financial system
   • Lending to the government in the form of a fixed-term bond, which is guaranteed to pay a fixed return each year

8. How can speculation lead to a market bubble?

   • Rising prices attract more buyers who expect further rises, so asset prices can detach from their underlying value
   • Speculation always lowers asset prices, since traders selling short keep prices falling in every market every year
   • Speculation ensures that asset prices track underlying value perfectly, so bubbles can never occur in any market
   • Speculation has no effect on prices, because asset values are always fixed by their replacement cost in the economy

9. What is market rigging in the financial sector?

   • A process by which a central bank buys government bonds to keep long-term yields at a constant level in the economy
   • Manipulation of prices or benchmark rates, for example by traders colluding to influence the interest rate benchmark
   • A situation in which every bank in a market offers exactly the same product, so that no price competition exists
   • A government policy that sets all interest rates at a fixed level, which removes competition between banks each year

10. Which regulatory response is most directly aimed at reducing the risk of moral hazard in banking?

    • Capital requirements that force banks to hold more of their own funds, so that losses fall on their owners
    • A policy of unlimited lending to any bank that asks for it, so that no bank is ever allowed to fail under any condition
    • A rule that allows banks to hold only government bonds, which removes all risk from their balance sheets for ever
    • A ban on all lending to households, which reduces the amount of credit available for risky mortgage lending

11. Which of these is an example of market failure from asymmetric information in the insurance or credit market?

    • Perfect competition, where all buyers and sellers have complete information and prices always reflect true risk
    • Price stability, where prices of financial products remain constant regardless of the risk of the borrowers involved
    • Efficient allocation, where lenders always know the true risk of each borrower and set rates that reflect it exactly
    • Adverse selection, where higher-risk borrowers are more likely to seek loans, raising the average risk for lenders

12. Which regulation would help reduce the risk of speculative bubbles in property markets?

    • Removal of all limits on mortgage lending, so that credit is always available to everyone who wants to buy a home
    • A policy of setting house prices by law at a fixed level, which prevents any change in prices in the market
    • A ban on all mortgages, so that property purchases are always made with cash and no lending is involved
    • Limits on the size of mortgages relative to income or property value, which restrain excessive borrowing

13. Why is the systemic risk of financial contagion a serious concern for regulators?

    • Contagion matters only for foreign banks, since domestic banks are never linked to one another through lending or payments
    • The failure of one institution can spread losses through interbank links and confidence, harming the wider economy
    • Contagion affects only the bank that fails, so the rest of the financial system and economy are always unaffected
    • Contagion always improves the stability of the financial system, because weak banks are removed and replaced quickly

14. A financial regulator introduces stress tests that examine how banks would fare in a severe downturn. What problem is this intended to address?

    • The shortage of physical capital in the banking sector, which stress tests increase by building new bank branches
    • The high level of tax revenue collected from banks, which stress tests reduce by lowering their profit each year
    • Asymmetric information and systemic risk, by revealing hidden vulnerabilities that might otherwise be unknown to outsiders
    • The low level of government spending on health, which stress tests are designed to raise in the economy

15. Which is the best evaluation of relying on self-regulation by financial institutions alone?

    • It guarantees that all bubbles are avoided, since self-regulated firms always sell assets at their true underlying value
    • It is unnecessary, because financial markets never suffer from any problem of information or risk at any time
    • It may fail to address externalities and moral hazard, since firms may not internalise the wider cost of their risk-taking
    • It always works perfectly, because firms have every incentive to avoid systemic failure that could harm their own business

16. Which is an example of speculation leading to a market bubble?

    • Investors buying houses expecting prices to keep rising, pushing prices far above rental values
    • Builders constructing homes at the same pace as demand, so that prices remain stable over the period
    • Governments fixing house prices by law, so that all sales take place at the same level every year
    • Households buying houses to live in at prices that match the rents they would otherwise pay each year

17. A bank takes on riskier loans after a government introduces deposit insurance that protects depositors. Which market failure is most clearly illustrated?

    • A positive externality, since deposit insurance has raised the wellbeing of depositors without any cost
    • Adverse selection, since the bank has chosen only the safest borrowers before the insurance was introduced
    • Moral hazard, since protection encourages the bank to take more risk because others bear the losses
    • Market rigging, since the bank has colluded with other banks to fix the interest rate on its loans

18. Why is central bank regulation of banks justified rather than leaving banks to the market?

    • Banks only affect their own shareholders, so regulation is needed only to protect the owners of the bank
    • Banks are always fully safe under free markets, so regulation reduces stability and so is never justified
    • Bank failures impose costs on depositors and the wider economy that individual banks do not fully bear
    • Banks never make losses, so regulation is needed only to raise the profits of the banking sector each year

19. What does liquidity mean in banking?

    • The number of branches a bank operates across the country, which determines its access to cash each year
    • The total value of a bank's share capital, which is set by the central bank in the annual regulatory review
    • The interest rate that a bank charges on its loans to customers with the highest credit ratings in the market
    • The ease with which an asset can be turned into cash quickly without a large loss of its value

20. A bank has £100m of equity and £1,000m of assets. What is its equity-to-assets ratio?

    • 10 per cent, since 100 / 1,000 = 0.1
    • 100 per cent, since equity always equals total assets in a bank's balance sheet by definition
    • 0.1 per cent, since 1 divided by 1,000 gives the ratio of equity to assets in the bank's accounts
    • 1 per cent, since 100 / 10,000 is the ratio of equity to assets measured per 10,000 units

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