Prof. Jayanth R. Varma’s Financial Markets Blog – 01 Apr 09

Wed, 01 Apr 2009

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 on Wed, 01 Apr 2009     11 comments permanent link


George Thekkekara wrote on Wed, 01 Apr 2009 12:36

Re: Do not blame the efficient market hypothesis

Hi Prof,

I agree with your broad point of view that EMH cannot be blamed directly for causing the crisis. However, I am not sure that belief in EMH would have helped avert it.

Let me take the specific examples that you have outlined and pose the counterfactual question i.e. what would EMH have recommended and what would that have resulted in?

1) Deposit insurance creating moral hazard : As per EMH, would you recommend that we repeal deposit insurance? If so, let us recall why this was created in the first place in 1933. In the absence of deposit insurance, bank runs were a common feature from 1929 to 1933, which is pro-cyclical and exacerbated the instability/demand destruction in the system post crash.

If not, then how do we determine the optimal capital requirement for banks? M-M theory says capital structure is irrelevant, right…

2) You mention that the increase in the profit share of financial sector from 20% to 40% of GDP implies that there is more risk/leverage. That is fair, but what is the right share that we should manage to? Who makes that decision? How does that incorporate the effect of more efficient business models (e.g internet etc)?

3) The third objection I have on EMH is the basic assumption that risk equals volatility. When Markowitz wrote the paper, he did not explicitly define risk that way, but found the volatility measure a “convenient market surrogate”…The EMH followers were the one who elevated volatility to that exalted pedestral. From an investment standpoint, I personally think that a value investing (Ben Graham) approach which relies on a setting an acceptable margin of safety to cover potential downside scenarios (max loss on individual security/odds of going insolvent for portfolio) is a more sensible way to think about it. Thanks, George

  • Prof. Jayanth R. Varma wrote on Wed, 01 Apr 2009 21:30

    Re: Re: Do not blame the efficient market hypothesis

    1. I think deposit insurance must have a deductible like other insurance contracts. I shall probably flesh this out in a separate post.

    2. My point is not that regulators should target a particular share of profits or GDP, but that a rising share should be a cause of worry. I think of it as a signal and not as a target.

    3. More than volatility, the reliance on the normal distribution is a mistake. But EMH is not bound up with this.

Paresh wrote on Thu, 02 Apr 2009 11:04

Re: Do not blame the efficient market hypothesis

In my view, EMH is more utopia than reality. Irrespective of the meltdown in the global markets, EMH was always more like a imaginary world. Consider the following two arguments made by EMH proponents: 1. Under the efficient market hypothesis, no single investor is ever able to attain greater profitability than another with the same amount of invested funds – I can’t help but wonder at this. Every day we see NAVs of mutual funds focused on similar sectors and with similar AUMs varying widely. Even if you take a wider horizon of say returns over 5 years, the figures will vary widely. Where is the efficiency? 2.Under the efficient market hypothesis, no investor should ever be able to beat the market, or the average annual returns that all investors and funds are able to achieve using their best efforts. – Another ‘global’ statement which gets attacked everytime the list of top 10 traders/investors is published. How can you explain a range of investors (institutional & individual both) outperforming the market year on year?

EMH would be practical if (and only if) machines participated in the markets without any human intervention. Despite the increasing use of computers, however, most decision-making is still done by human beings and is therefore subject to human error & emotions. Even then since the methods of stock analysis differ so widely from each other, achieving 100% efficiency would be difficult.

  • Prof. Jayanth R. Varma wrote on Thu, 02 Apr 2009 11:24

    Re: Re: Do not blame the efficient market hypothesis

    The current crisis (and the tail risk that it demonstrates) has made it a lot easier to defend the EMH. What looks like a violation of EMH if you assume a normal distribution could be quite consistent with EMH if you consider highly skewed distributions.

    A good example of tail risk wiping out decades of outperformance is Bill Miller’s Legg Mason Value Trust. Miller outperformed the S&P 500 fifteen years in a row till 2005. Then the tide turned and he lost so much money in the last couple of years that recently the lifetime performance of the fund was trailing the market index.

    If that is what you want, it is much cheaper to systematically write out of the money options. You will beat the market year after year after year (by pocketing the premiums) until one day you lose it all and more when the options get exercised against you.

    Even Warren Buffet is not immune to this criticism – he has been writing put options on a colossal scale.

Shankar Venkataraman wrote on Thu, 02 Apr 2009 20:06

Re: Do not blame the efficient market hypothesis

Prof. Varma

I think you are conflating two ideas here. The first idea is the belief that markets are the most efficient means of solving most resource-allocation problems (Milton Friedman) and the second is the EMH – the efficient market hypothesis (Eugene Fama), which simply states that securities prices reflect all available information.

I would like to think of the first idea as a belief in the efficiency of markets and the second as a belief in the efficient market hypothesis – two different, albeit related ideas.

Skimming through the Turner report, I find no explicit reference to the idea that Lord Turner believes that the EMH, in particular, created the current crisis, as you have asserted. As you rightly point out, the good Lord rails against something called “efficient market theory” which is not quite the EMH – it has more to do with the role of regulation in markets, which is much closer to Friedman than it is to Fama.

You also say that “an EMH believer would not have invested in a Madoff fund because according to the EMH, Madoff style returns are not possible” – I am not so sure about that. To the extent that I believed that Madoff was a crook and had inside information that generated higher-than-normal returns, I would have to be a believer in the strong form of the EMH in order to stay away from investing in the fund. Investing in the Madoff fund might not necessarily contradict a belief in weak or semi-strong efficieny. Investing in Madoff, from that perspective, might be viewed as no different from investing in Bill Miller’s funds.

The idea that if more people believed in the EMH, we could have averted this crisis is an untestable proposition. Typically, though, the people who believe in the EMH are also the people who believe in the efficiency of markets – after all, both Fama and Friedman are from Chicago. So, I suspect that believers in the EMH would urge, on average, lesser rather than greater regulation.

Shankar Venkataraman

  • Prof. Jayanth R. Varma wrote on Thu, 02 Apr 2009 21:45

    Re: Re: Do not blame the efficient market hypothesis

    1. Informative efficiency (EMH) and allocative efficiency are intertwined in the Turner Review. Of the five points on printed page 39 (PDF page 41), (i) and (iii) are probably EMH, (v) is probably allocative and (ii) and (iv) are probably both.

    2. Markopolos (whom I have blogged about) disposed of the front running idea very simply. Front running is a highly profitable activity and does not require Madoff to borrow money at 16% implied interest. Markopolos noted that if Madoff turned out to be front running, he was entitled to a bounty from the SEC, yet he told the SEC that it was most unlikely.

    3. Friedman did not advocate less banking regulation – he recommended a form of narrow banking far more restrictive than Glass Steagal. I have already quoted Miller recommending higher capital requirement. Genuine free market theorists would not combine loose regulation with deposit insurance. They would want to give up one of the two. The ones who want to keep both are lobbyists for the banks and not genuine free market theorists.

Naveen wrote on Fri, 03 Apr 2009 16:50

Re: Do not blame the efficient market hypothesis

Prof. Varma.. as far as I have read and understood Friedman indeed supported free banking with just one regulation.. for 100% reserve requirement. Please check the paper cited below.

  • Prof. Jayanth R. Varma wrote on Fri, 03 Apr 2009 17:12

    Re: Re: Do not blame the efficient market hypothesis

    Exactly, that is the most extreme form of narrow banking. A bank with 100% reserves cannot fail (unless the government defaulted on the T-bills that the bank bought!). The Friedman narrow bank can’t make subprime loans, invest in CDOs, or buy any toxic securities for the simple reason that it cannot make loans or buy securities. Friedman argued that the entity that did make loans or buy securities should not accept deposits.

    Bank lobbyists wrote a lot of arcane and highly sophisticated papers to argue that there are great efficiencies when a bank that accepts deposits also makes loans.

    • Ritwik wrote on Sat, 04 Apr 2009 13:35

      Re: Re: Re: Do not blame the efficient market hypothesis


      It is a surprise to me that Friedman was a supporter of the full reserve banking theory, given that he utterly disregarded the Austrian credit cycle theory (the former seems to be predicated upon the latter to some extent).

      Like you mentioned, insistence on loose regulation AND deposit insurance is surely a bank lobbyist position and not a true free market position. However, a position of deposit insurance backed with strong regulation hardly appears to be a free-market position. It seems that the only true free market position is one of no deposit insurance and loose regulation (which may not be as extreme as full reserve banking).

      Also, given that behavioural finance theorists also believe in mean reversion, I think that a test of excessive returns alone may not be adequate to test the credibility of the EMH. Reading Shleifer and Shiller gave me this impression, though I may be getting this completely wrong.

      Given its insistence on the long run and the fact that tail risks as modelled by Mandelbrot and others (which are frequently extolled by behavioural finance theorists)can also be appropriated by EMH theorists, I feel that EMH also seems to be evading Popper’s test of falsifiability. This is charge that Soros often makes, though I have no clue how exactly all this relates to the current crisis.

Siddharth Sharma wrote on Sun, 05 Apr 2009 13:49

Re: Do not blame the efficient market hypothesis

The informational EMH is really besides the point now.

The fact is that some markets, some of the time get really inefficient and wild.

People like Soros have been calling out bubbles since forever. He tried shorting the dot com bubble and failed , not because the market was in any way “efficient”, but because it was way too wild (you should know how option traders used to trade yahoo, it was a wild game with no relation to fundamentals) to have any kind of efficiency. His inability to make money out if it didn’t make it any less of a bubble.

The fact is that money cannot be made consistently by real partipants out of wild market gyrations as there are transaction costs and great risks of getting caught on the wrong side of a mania / panic inefficiency. not really because every market is always pricing securities very efficiently.

Should i be shorting a company trading unreasonably at a PE of 500 the next time? At my peril, who knows how long the mania lasts.

The CDO market was completely mispricing tail risk as recently as end of 06. did john paulson get just plain lucky with his bet?

The Oil market seems to be clueless in pricing oil and was driven entirely by money flows in 2008. Soros warned of the leveraged oil bubble too. Did he get lucky again?

I am sure there exist sophisticated arguments to obfuscate and explain away each of these market failures and market design problems (leverage creating procyclical price patterns as happened in the jan 08 indian market crash as one more example).


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