The FSA has published a speech that Verena Ross, Director of Strategy and Risk, gave on 18 June 2009 at the Chartered Financial Analysts Annual Conference. The speech was entitled Efficient markets and market regulation.
At the start of her speech Ross mentioned that in the Turner Review the FSA had distinguished five propositions in the Efficient Market Hypothesis which had implications for the regulatory approach followed by regulators. In summary these were:
- Market prices are good indicators of rationally evaluated economic value.
- Securitised credit has improved allocative efficiency and financial stability.
- Mathematical analysis can deliver robust quantitative measures of trading risk.
- Market discipline can be used as an effective tool in constraining harmful risk taking.
- Financial innovation can be assumed to be beneficial.
The financial crisis has shown that these assumptions can be challenged and that such challenges could have major implications for the future design of financial regulation.
Ross then discussed transparency and market efficiency, stating that there are many indications that market efficiency decreased during the crisis. She also stated that the issue of whether more transparency is needed is likely to vary significantly across different securities markets, especially in times of severe market stress, and will depend on the characteristics of that market and how much of the information investors can absorb, understand, trust and use.
Ross then covered irrationality, the Efficient Markets Hypothesis and the regulator. In this part of her talk she concluded that many structured products are too complex even for sophisticated investors to understand. Furthermore, individual sophisticated investors were overconfident about the risks involved in these structured products. They also relied too much on credit rating agencies instead of making judgments based on understanding the products they invest in.
She then discussed the Efficient Market Hypothesis, asking the question whether the market was able to iron out its own failings. She noted that opinions on this were divided with even one of the founders of the Efficient Markets Hypothesis questioning whether such a hypothesis still applies at the macro-economic level.
In the final part of her speech Ross asks the question of whether and how regulators should intervene and try to prevent the build up of bubbles. Her response was that this was an extremely difficult question to answer against the backdrop of the financial crisis. She also said that the "answer depends on the ability of regulators to judge the future better or worse than markets do. In order to try to avoid the build up of asset price bubbles, regulators also need to take the punch-bowl away exactly at a time when markets are apparently doing well. Therefore, interventions by regulators involve not only difficult judgments, but also significant reputational risks. But the crisis has shown, for us regulators to sit back and rely purely on the market to avoid asset price bubbles does not work either."
View Efficient markets and market regulation, 18 June 2009