Market Failure and Behavioral Bias Theory in Explaining Financial Crises

Posted: July 7th, 2022

Instructions
CW2 Part 2 (60% of CW2 and 30% of the total overall module mark)
1. You must write a short focused essay which analyses and critically evaluates one of the two topics below. (1,500 words maximum). You will receive your grade, comments, overall feedback and feedback on the criteria via Turnitin within 3 weeks of submission.

Essay topics: PICK Q1. HIGHLIGHTED IN YELLOW
1. Critically assess the extent to which market failure and behavioural bias theory can explain financial crises in general, referring to evidence from one financial crisis.
2. Critically assess the extent to which market failure and behavioural bias theory can be used to explain bank failures during the 2008 financial crisis, referring to evidence from one bank failure that occurred during the 2008 financial crisis.
You MUST NOT EXCEED the 1,500 word limit or you will lose marks as follows:
a. 10 marks deducted for exceeding the word limit by up to 250 words
b. 20 marks deducted for exceeding the word limit by 251-500 words
c. 30 marks deducted for exceeding the word limit by 501-750 words
d. 50 marks deducted for exceeding the word limit by more than 750 words

You must provide a word count at the end of the essay. The word limit includes citations, tables and charts, but does not include the reference list or the word count statement.

Suggested structure for your Essay. (follow these step systematically)
1. Short introduction, say what your aim is, why and how you will achieve it within the essay.
2. A discussion of the main issue/focus/history or background to the organisation/sector/issue. You will be presenting some background evidence here that will be drawn from a variety of sources many of which will be electronic and/or web pages. You must cite in the essay all your sources as you use them. Avoid direct quotes, it is bad style. Take the ideas and evidence from your sources, write it up in your own words and cite the sources after each relevant sentence. Use the Harvard style. If you are unsure how to deal with websites, then go to the library and get their Harvard referencing style guide.
3. A discussion of the relevant concepts and theory that you are using to examine the issue, explaining why they are relevant to the issue. You must consider market efficiency, the economic market failure theory, regulation theory and the theory of behavioural bias. You need to look market failure issues such as lack of competition, externalities, moral hazard and adverse selection, for example, and behavioural factors and biases such as herding, confirmation bias, overconfidence, present bias, etc. You need to explain why the theory and/or concepts are relevant in the context of your essay focus. You might be using them to examine causes and effects, evaluate outcomes, or judge responsibility for outcomes for example. In this section you are more likely to have sources from text books, web sites and, specialist magazines such as the economist, etc. Information and ideas from these must all be cited and referenced using the Harvard style.
4. A section where you use detailed evidence from different sources about the issue together with the theory and concepts you have identified, to explore what happened. This is analysis. The idea is to discuss, evaluate and comment. Your comments are your views, and should be drawn and based directly from your theory discussion and evidence evaluation. In this section you are more likely to have sources from academic journals, research papers from global institutions such as the Bank for International Settlements and the Bank of England, specialist magazines such as the economist, etc.
5. A short conclusion, no new material here.

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Market Failure and Behavioral Bias Theory in Explaining Financial Crises: Evidence from the 2008 Financial Crisis

Introduction:
The aim of this essay is to critically assess the extent to which market failure and behavioral bias theory can explain financial crises, with a specific focus on the 2008 financial crisis. The essay will examine the background and context of the crisis, discuss relevant concepts and theories, and analyze the evidence to evaluate the role of market failure and behavioral biases in causing the crisis.

Background to the 2008 Financial Crisis:
The 2008 financial crisis was a global economic downturn characterized by the collapse of major financial institutions, a severe credit crunch, and a deep recession. It was triggered by a combination of factors, including subprime mortgage lending, securitization, excessive risk-taking, and regulatory failures. These events led to a systemic failure that had profound implications for the global economy.

Relevant Concepts and Theory:
2.1 Market Failure Theory:
Market failure theory suggests that in certain circumstances, markets may not allocate resources efficiently, leading to suboptimal outcomes. Key market failures relevant to the 2008 financial crisis include information asymmetry, externalities, moral hazard, and adverse selection. These failures contributed to the mispricing of assets, the proliferation of risky lending practices, and the breakdown of trust and confidence in the financial system.

2.2 Behavioral Bias Theory:
Behavioral bias theory explores the cognitive and emotional biases that influence individual decision-making. Various biases, such as herding behavior, confirmation bias, overconfidence, and present bias, can distort market participants’ judgments and lead to irrational behavior. These biases played a significant role in fueling the housing bubble and the subsequent financial crisis, as investors and financial institutions underestimated risks and relied on flawed models and assumptions.

Analysis of the 2008 Financial Crisis:
3.1 Market Failure Analysis:
a) Information asymmetry: The complexity of financial products, such as mortgage-backed securities, made it difficult for investors to accurately assess their risk profiles. This information asymmetry led to mispricing and overvaluation, eventually resulting in substantial losses.
b) Externalities: The interconnectedness of financial institutions created systemic risks, where the failure of one institution could rapidly spread throughout the entire financial system. The collapse of Lehman Brothers, for instance, triggered a contagion effect, exacerbating the crisis.
c) Moral hazard: The expectation of government bailouts and the “too big to fail” perception encouraged excessive risk-taking by financial institutions. This moral hazard distorted incentives, leading to imprudent behavior and increased vulnerability to financial shocks.
d) Adverse selection: The securitization of mortgages resulted in a misalignment of incentives, as lenders and investors were detached from the creditworthiness of borrowers. This adverse selection problem contributed to the deterioration of loan quality and the subsequent wave of defaults.
3.2 Behavioral Bias Analysis:
a) Herding behavior: The herd mentality among investors and financial institutions fueled the rapid expansion of the housing bubble. As the market euphoria intensified, individuals became more prone to follow the crowd, reinforcing the unsustainable boom.
b) Confirmation bias: Market participants selectively sought information that confirmed their preconceived notions of perpetual housing price appreciation. This bias prevented them from recognizing the underlying risks and contributed to the underestimation of potential losses.
c) Overconfidence: The overconfidence bias led to an underestimation of the probability of adverse events and a belief in the ability to manage risks effectively. This overconfidence fueled excessive risk-taking and amplified the severity of the crisis.
d) Present bias: Borrowers and lenders exhibited present bias by focusing on short-term gains while neglecting long-term consequences. This bias drove the proliferation of risky lending practices, such as subprime mortgages, which eventually led to defaults and foreclosures.

Conclusion:
The 2008 financial crisis was a complex event influenced by a combination of market failures and behavioral biases. Market failure theory provides insights into the structural flaws of the financial system, highlighting issues such as information asymmetry, externalities, moral hazard, and adverse selection. Additionally, behavioral bias theory helps explain the irrational behavior and decision-making that fueled the crisis. By critically assessing these theories and examining the evidence, it becomes evident that both market failure and behavioral bias theory played significant roles in the occurrence and severity of the 2008 financial crisis.