March 17, 2010
Efficient Markets after the Financial Crisis
Posted by Gordon Smith

In thinking about ways to integrate the financial crisis into the basic business associations course, the topic that keeps coming to mind is the Efficient Market Hypothesis (EMH). What does the recent financial crisis tell us about EMH? And what are the implications of our newfound knowledge on market regulation?

Inspired by my Markopolos post, Glom friend Darren Roulstone has nudged me in the direction of some answers, courtesy of a recently published paper by Ray Ball of the University of Chicago entitled, The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned? This short paper provides an excellent description of the insights and limitations of EMH, but for present purposes, I am most interested in the implications of EMH for market regulation.

Ball begins with the emerging conventional wisdom on efficient markets:

The reasoning boils down to this: swayed by the notion that market prices reflect all available information, investors and regulators felt too little need to look into and verify the true values of publicly traded securities, and so failed to detect an asset price “bubble.”

As applied to investors, the argument is silly. As applied to regulators ... well, that's not so obvious. Back to Ball:

The crisis has prompted many to conclude that financial regulators were excessively lax in their market supervision, due to a mistaken belief in the EMH. This conclusion is made explicit in the UK’s Turner Review. Perhaps not surprisingly, the report advocates more regulation. It reasons as follows:

The predominant assumption behind financial market regulation—in the US, the UK and increasingly across the world—has been that financial markets are capable of being both efficient and rational and that a key goal of financial market regulation is to remove the impediments which might produce inefficient and illiquid markets…. In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism.

This characterization of what the EMH implies for regulators makes sense in one respect. If the market does a good job of incorporating public information in prices, regulators can focus more on ensuring an adequate flow of reliable information to the public, and less on holding investors’ hands. Consistent with this view, in recent decades there does appear to have been increased emphasis by regulatory bodies worldwide on ensuring adequate and fair public disclosure.

Otherwise, the characterization of the role of the EMH in the crisis falls short of the mark. If regulators had been true believers in efficiency, they would have been considerably more skeptical about some of the consistently high returns being reported by various financial institutions. If the capital market is fiercely competitive, there is a good chance that high returns are attributable to high leverage, high risk, inside information, or dishonest accounting. True believers in efficiency would have looked more closely at the leverage and risk-taking positions of Lehman Brothers, Bear Sterns, AIG, Freddie Mac and Fannie Mae, and banks and investment banks generally. They might have questioned the source of the trading profits of hedge funds like Galleon, and discovered some using inside information. And they would have been exceptionally skeptical of the surreally high and stable returns reported over an extended period by Bernie Madoff.

Nifty argument. The problem wasn't that regulators believed too much in EMH. The problem was that they didn't believe it enough! 

Economics, Securities | Bookmark

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