The Financial Services Authority (FSA) has just issued the Turner Report which traces the causes and suggests the cure for the current financial crisis that it describes as the worst in a century. It notes that “the crisis also raises important questions about the intellectual assumptions on which previous regulatory approaches have largely been built. At the core of these assumptions has been the theory of efficient and rational markets. Five propositions with implications for regulatory approach have followed:
(i) Market prices are good indicators of rationally evaluated economic value.
(ii) The development of securitised credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability.
(iii) The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk.
(iv) Market discipline can be used as an effective tool in constraining harmful risk taking.
(v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added.”
“Each of these assumptions,” the report claims “is now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities.” Martin Wolf suggests the report is “a start. More learning must follow.”
This is a direct challenge to finance and accounting faculty in universities across the world who have been teaching efficient market theory to legions of MBA and BBA students. Thus far universities have been relatively immune from criticism. Will this report force them to rethink what they teach? Just a week ago the New York Times was asking whether it is was time to retrain B-schools. Several Deans opined that the curriculum would need revision in light of recent events. In particular, there was talk of more emphasis on the remaining systematic risk that tends to get ignored in the excitement about how diversification removes non-systematic or idiosyncratic risk.