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March 26, 2010 2:00 am
There are two efficient market hypotheses. One is the bold, unsubstantiated proposition that financial markets are close to perfect and all-knowing. This theory was ferociously and convincingly attacked by Robert Shiller and Lawrence Summers three decades ago and quietly abandoned by its progenitors in the 1990s - although it lived on zombie-style in textbooks, central bank policy and some parts of the financial press until recently. When, these days, a pundit or government official rails against "efficient market theory", this is what they mean.
A second efficient market hypothesis, however, deservedly survived the financial crisis. It holds simply that it is very hard for any investor (or regulator, or journalist) consistently to outsmart the market. Evidence keeps pouring in to back up this "No Free Lunch" theory, as economist Richard Thaler dubbed it in these pages last year, even as its "Price is Right" counterpart has been shown wanting.
The differing fates of these two hypotheses ought to inform our approach to reforming financial regulation. It can no longer be argued with a straight face that markets will, on their own, arrive at something close to an economically optimal result - a belief that helped drive deregulation over the past few decades. Yet it is not as if anyone else would do a better job than markets at setting prices and allocating capital. They would probably do worse. That is why giving regulators more leeway and authority to identify and halt overly risky behaviour - a pillar of most reform proposals in the US and UK - is unlikely to solve anything.
One way to overcome this might be to keep regulation simple. Stick with a few clear rules, the thinking goes, and while you may not get a perfect result, you stand a chance of reining in some excesses. This sounds reasonable, but the recent revelation that Lehman Brothers faked its balance sheet at the end of every quarter to reduce its leverage ratio shows that the clever denizens of Wall Street and the City of London will find ways to subvert even the clearest of rules.
Maybe it is the denizens of Wall Street and the City - or their attitudes - that need to change. In the 1980s, investment banks, encouraged by regulators, began a transformation from stodgy, tradition-bound institutions to restless, relentless seekers of profit. Some of that change was good but, ultimately, it gave us a few powerful, global companies bound by no clear standards of behaviour, where appalling conflicts of interest were accepted and pay practices encouraged the most greedy, short-sighted thinking imaginable. The culture was toxic.
Partially reversing that transformation - making bankers gentlemanly again, to steal a phrase from City chronicler and critic Philip Augar - will not be easy, or happen on its own. It seems like a good unifying principle for regulatory reform, but, as Adair Turner, chairman of the Financial Services Authority, put it last week at a meeting of the Future of Banking Commission: "We simply don't know whether we really have tools which can change culture."
Even so, regulators could do much more to push bankers, brokers and traders towards seeing themselves as members of professions with ethics, standards and limits. The Glass-Steagall Act's separation of underwriting from banking in the US may not have made a lot of sense by the 1990s, but I have heard from enough Wall Streeters who say its repeal unleashed an era of infectious greed to believe there is something salutary in isolating different financial activities. The "Volcker rule" on the table in the US, which would split proprietary trading from trading for customers, is a step towards rebuilding some barriers.
Another culture-changing potential reform - one not being seriously considered on either side of the Atlantic - has to do with the ownership structure of financial organisations. It is no accident that all investment banks were once structured as partnerships, and mutuals once dominated insurance. These structures impose limits on risk-taking (and pay) that publicly traded companies do not. The law ought to give them a leg-up.
The past few years have been a convincing demonstration that smart, highly paid financial market participants cannot be relied on to get things right. But neither can regulators. Regulatory reform has to be about finding ways around the errors of both. The writer is editorial director of the Harvard Business Review Group and author of The Myth of the Rational Market
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