Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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

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


5 responses to “Do not blame the efficient market hypothesis

  1. Ritwik April 1, 2009 at 2:10 pm


    I think a large amount of the criticism heaped against the EMH in the backdrop of the current crisis is because people conflate the ideas of the EMH with the idea of greater deregulation, owing to the same set of economic proponents for both (the Chicago School, Friedman and Lucas in particular). The EMH is also based upon the presupposition of zero transaction costs and unrestricted ability to short, both of which are prevented by regulation and margining usually. Moreover, the explosion of quantitative finance based upon the same assumptions as the EMH description of the risk-return paradigm (normal curve etc.) which later went wrong places EMH in criticism bracket. Due to its central premise of investor rationality or randomly distributed irrationalities that cancel, the bracketing of EMH with quantitative finance is further explained. The lead actors of the EMH movement are also some of the more prominent forces in the free-market and quant. fin. explosion, and the conflation is thus natural, though certainly somewhat erroneous.

    I think the debate over the EMH is intellectually fine-grained and does not necessarily have have very direct policy implications that sit comfortably on the usual left-right dichotomy. However, I do not really understand your point about the supra-normal profits being made by banks pointing towards supra-normal risks. Sure, the profits climbed due to high RoE, which in return climbed due to excessive leverage, which is risky. But I am not sure if the EMH even addresses the risk of leverage. In fact, it assumes the possibility of infinite leverage when it pre-supposes free shorting. More generally, I am not sure if a business entity’s risks can be understood analogous to an investor’s risk. There can be some analogy with the business cycle being at the risk of both, but I am not sure if business risk accurately captures credit risk. Please explain this point further at your convenience.

  2. Jayanth Varma April 1, 2009 at 3:48 pm

    When leverage rises everything else remaining the same, ROE rises but profits actually fall because part of the old profits has to be paid out as interest. ROE rises because the denominator falls by a larger percentage than the numerator. Therefore rising leverage explains rising profitability but not rising profits.

    On the leverage question itself, I love Miller’s paper “Do the M & M propositions apply to banks?”, Journal of Banking & Finance 19 (1995) 483-489. I quoted a short passage from this, but the paper is worth reading in full.

  3. Amelia November 10, 2009 at 3:59 pm

    Hi there,

    I have a question on EMH and would kindly need your help in it.

    The government of Kuwait offered to sell 170 million British Petroleum shares, worth about $2 billion. Goldman Sachs, a U.S investment banker, was contacted after the stock market closed in London and given one hour to decide whether to bid on the stock. They decided to offer 710.5 pence ($11.59) per share and Kuwait accepted. Then Goldman Sachs went looking for buyers. They lined up 500 institutional and individual investors worldwide, and resold all the shares at 716 pence ($11.70). The resale was complete before the London Stock Exchange opened the next morning. Goldman Sachs made $15 million overnight.

    Discuss this deal from the viewpoint of market efficiency.

    • Jayanth Varma November 10, 2009 at 6:17 pm

      What you are really saying is that the bid-ask spread for BP shares for a transaction of that size ($2 billion) was 5.5 pence or about 0.6%. For transactions of this size, the spread does not appear outrageous.

      There are several reasons why Kuwait does not disintermediate Goldman and sell directly to those 500 buyers. First, it does not know those 500 potential buyers. Second, it is easier for Goldman to make an assessment of whether Kuwait is selling on the basis of some inside information about the oil market and/or BP or is selling for other reasons. Third, Kuwait does not want to take the price risk and the execution risk while Goldman is willing to take that risk for a price.

      Probably a lot of Goldman’s profit was only compensation for the risk that it took. Even if it shorted some index futures somewhere to hedge market risk, it was still exposed to huge risk for the few hours during which it held the position.

      The critical question is whether Goldman has acquired a monopoly of this business after the bankruptcy of some key rivals. Apart from that, I do not think this really poses any problems for market efficiency unless you interpret it so literally as to assume that there are no bid ask spreads at all.

  4. Melvin March 25, 2010 at 11:14 pm

    How can you use EMH to anternatively explain the investor behaviour in S&P 500 during and after crisis?

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