The Efficient Capital Market Hypothesis Revisited: Implications of the Economic Model for the United States Regulator

Abstract

Most capital market regulation is expressly or implicitly based on a theory of how the regulated market works. That is, the regulation requires actor A to take action X or prohibits A from taking action Y—all with the purpose of getting the market to do M or preventing the market from doing N. Such regulation rests, explicitly or by implication, on some theory that connects the actions X or Y—by actor A—with market reactions M and N. In the United States, the Efficient Capital Market Hypothesis is the basis for most regulation. The behavioral finance’s approach can be integrated into the same framework of law and economics, of which it constitutes an improvement capable of explaining the failure of the EMCH in some marginal cases. Except in short periods like the high-tech bubble, however, behavioral finance may only explain the actions of certain investors, such as individuals, and not the actions of the market as a whole. In the United States, arbitrageurs will overcome psychologically based trading in most cases. The Efficient Capital Market Hypothesis is an economic model, which assumes that the market is comprised of a large number of rational participants and that information is fully and quickly available to them. In the U.S. and the U.K., the elements of an efficient market can generally be traced. In turn, information is provided to the market by corporate insiders. Thus, a risk exists that it be limited, inaccurate, or fraudulent. As a general matter, “corporate governance” refers to an important legal relationship that exists between managers, auditors and the board of directors. In the United States, the company’s management governs the company under the supervision of the board of directors and for the benefit of its shareholders. Auditors ensure that the management complies with accounting standards, thereby providing shareholders and prospective investors with an accurate understanding of the company’s financial health. Two factors played an important role in leading to the corporate scandals of the early 2000’s: a) auditors’ misperception that their responsibilities was to serve the management, and b) the need for CEOs and CFOs to ensure that financial information (particularly referred to quarterly and annually financial disclosures) be accurate. This paper argues that the ECMH still provides (some 40 years after its widespread dissemination) the theory of how markets work, which is the most useful theory for regulators in the United States.