Do not blame the efficient market hypothesis
I have a piece in today’s Financial Express arguing that we should not blame the Efficient Market Hypothesis (EMH) for the current crisis. I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously.
In the run up to the G20 summit, several global regulators have put out blueprints for reforming global financial regulation – apart from the Turner review in the UK, we have had proposals by the US Treasury, the People’s Bank of China, former Fed Chairman, Alan Greenspan and several academics and practitioners.
Several of these proposals make eminent sense: greater capital requirements for banks and near banks; orderly bankruptcy process for systemically important financial institutions; more robust regulation and supervision.
The emerging consensus is however wrong in asserting that mistakes in financial regulation were caused by the belief in the Efficient Market Hypothesis (EMH). The Turner review says for example that: “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.... 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.”
I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously. Had they done so, regulators would not have been as complacent as they were during the last decade. The EMH very simply states that there is no free lunch; whenever you see an abnormally high return, EMH warns us that there must be an abnormally high risk lurking behind it.
For example, an EMH believer would not have invested in a Madoff fund because according to the EMH, Madoff style returns are not possible. In fact, critics say that an EMH fanatic would not pick up a hundred rupee note from the road because according to the EMH, that note cannot be there – either the note is fake or somebody must already have picked it up. Yes, EMH can make you miss some investment opportunities, but it will also protect you from hidden and unknown risks.
What would the EMH have told Greenspan when he saw the profits of the financial sector rise from 15-20% of total corporate profits in the 1970s and 1980s to over 40% in the last decade? EMH would have told him that there are only two possibilities: either financial institutions were becoming impregnable monopolies or they were taking incredibly high risk. The former hypothesis could be easily ruled out because financial deregulation was making the financial sector highly competitive particularly when one considered competition from the shadow financial system and from foreign players. If Greenspan actually believed in the EMH, he should have been very very worried.
When banks tried to make money with “arbitrage CDOs” by tranching pools of securities in different ways, the EMH would have argued that the value of a pie does not depend on how it is cut. Investors and regulators who believed in the EMH would have been sceptical of some of those AAA ratings.
Again, when banks increased their leverage ratios to absurdly high levels, a regulator who believed in the Modigliani-Miller (MM) theory of capital structure would have mulled over Miller’s own words (way back in 1995): “An essential message of the MM Propositions as applied to banking, in sum is that you cannot hope to lever up a sow’s ear into a silk purse. You may think you can during the good times; but you’ll give it all back and more when the bad times roll around.”
The MM theory implies that banks seek higher leverage mainly to exploit the subsidy provided to them in the form of deposit insurance and lender of last resort. Greater capital requirements for banks do not therefore have a significant social cost though they are costly to the shareholders and managers of the banks.
As Nouriel Roubini points out: “people are greedy in every industry, people in every industry try to avoid regulation sometimes with lies, sometimes by cheating or avoiding, whatever. But there’s only one industry, the financial industry, in which this thing leads, over and over again, to financial crisis. It happens for two reasons. One because banks have deposit insurance and deposit guarantees.... Two, we have lender of last resort support”.
The point is that regulators who believed in the EMH and the MM theory would have regulated banks far more tightly. Alan Greenspan claims that prior to 2007, the central premise was that “the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency.” Sorry, the EMH says no such thing. In fact, the theory says that if owners and managers can keep the profits and pass on losses to the taxpayers, they would be selfish enough to avoid keeping a sufficient buffer. The EMH would have disabused Greenspan and other regulators of the naïve assumption that bankers could be trusted.
Posted at 11:04 am IST on Wed, 1 Apr 2009 permanent link
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