A Fundamental Re-Examination of Efficiency in Capital Markets in Light of the Global Financial Crisis
31 Pages Posted: 18 Dec 2013 Last revised: 28 Apr 2014
Date Written: December 12, 2013
The global financial crisis ('GFC') has severely shaken scholarly and regulatory belief in the efficient market theory and the capacity of markets to respond to issues such as information asymmetry, conflicts of interests and risk anomalies. Policy makers, regulators and scholars are fundamentally re-examining their theoretical and empirical efficiency frameworks. Most readers probably have some knowledge of the Fama efficient markets theory and the Efficient Capital Markets Hypothesis ('ECMH'). However, the ultimate goal of the efficient markets theory, the ECMH assumptions, empirical research on efficiency in capital markets, and the policy implications flowing from efficiency theories and research are not well understood.In this article we argue that the theoretical bases of the ECMH are sound. There is considerable evidence of irrational market behaviour and long periods of security prices deviating substantially from fundamental valuations that can lead to crises as markets overshoot or otherwise collectively misprice risk.
This article is not proposing a new efficiency theory. Instead, we are calling for policy makers, regulators and the judiciary to enact, enforce and interpret capital market regulation through a clearer lens refocused to assess regulatory efficiency issues over longer periods and for their ultimate effects on the real economy and the country as a whole. Regulation can enhance the efficient operation of markets, promote the efficient allocation of scarce capital, and improve long-term economic returns. However, to achieve these goals, capital market policy must be designed to serve the 'public interest' of a country rather than the interests of some market participants. Policy intended to enhance efficiency in capital markets and regulatory efforts to 'maintain, facilitate and improve the performance of the financial system ... in the interests ... of efficiency and development of the economy' should be based on a high level efficiency rationale, growth in the real economy, and a long time horizon. A long-term allocative efficiency rationale enables the policy and regulatory efforts to be assessed holistically, incorporating competing systemic efficiency measures, incentives issues, public interest factors, and longer-term costs and benefits.
The article is in four parts. Part I summarises the efficiency framework adopted by global regulators. Part II reviews the efficient markets theory and the ECMH. Part III analyses and critiques the empirical and observational bodies of evidence on price, market and allocative efficiency. Part IV discusses the appropriate policy response arising from this analysis.
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