Market Failure: Sub-Optimal Allocation of Resources By Credit and Capital Markets and Consequent Banking and Sovereign Debt Crises

Abstract

In earlier chapters we have noted that the purpose of primary markets, both credit and capital, is to allocate resources efficiently -optimal resource allocation as it is known. In particular the function of the capital market is to allocate resources to a household, a corporate, a bank or a sovereign on the basis of a ‘business plan’ which demonstrates a high probability that the entity raising funds will be able to meet the P&I or return-on-equity requirements of the particular entity undertaking the financing. If the P&I payments are met on the due dates or the required rate of return is achieved then we conclude that the allocation of resources has been optimal. Some households and some corporates will, of course, fail to meet their P&I payments for ‘idiosyncratic’ reasons, i.e. just because in the normal course of events some households have bad luck or some companies make mistakes. Such cash flow losses to the lender are to be expected but can be met out of the risk premium paid by all borrowers.