Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

EMH and financial crises

We now apply the same logic to financial crises. Suppose that someone could predict that a financial crisis would occur next month. What would you do today? Most probably you’d sell all your shares (and maybe even your house), take all your money out of the bank and stuff it under the mattress. If everyone did the same, it would cause a financial crisis all right, not next month, but today!

Thus the very act of correctly being able to predict a financial crisis would cause it to happen immediately. Man, that’s deep! Therefore, no responsible economist would ever claim to be able to predict when a financial crisis will occur, even though they know that they can happen anytime and probably more often than you’d think (check out the earlier section on those dreaded fat tails, ‘Appreciating the limitations of the

‘average’: Asset returns have fat tails!’).

So please don’t judge economists by their ability to predict financial crises. Economic theory says that it’s impossible!

Trying to Stop the Next Crisis

Financial crises are so devastating and their social costs so huge that anyone who could come up with a way of stopping them from happening (or reducing their frequency and impact) would deserve a Nobel Prize (in Peace as well as Economics!).

This area is another one where economists’ knowledge is far from perfect.

Nevertheless, join us as we go through three possible, potential solutions.

Suggesting smarter regulation

For a long time, regulation was a dirty word in the financial sector. After all, the argument went, why would a nation want to restrict people trading with each other by introducing red tape? The crisis changed everything: policy makers quickly realised that rather than having too much regulation, countries had far too little! Here we take a look at some of the major changes to the regulatory framework in the UK, but other advanced economies (including the US) have taken similar measures.

As you know, during the crisis a number of banks failed. These failures were bad news because people began to lose confidence in the financial system as a whole. To make matters worse, policy makers were taken by surprise and found that they didn’t have the tools to deal with bank failures in a calm and orderly fashion. Instead, they made policy on a rather chaotic ad-hoc basis.

Also no single body had overall responsibility for ensuring the nation’s financial stability. One of the first changes occurred in 2009, when the Bank of England (‘the Bank’) was formally given responsibility for safeguarding the financial system. Alongside this change, a Special Resolution Unit was set up inside the Bank whose job was to manage the failure of banks that found themselves in trouble. The idea was that future bank failures should be carried out in an orderly fashion that minimised the systemic impact of the failure on other parts of the financial system.

In 2013 a number of major changes were introduced that built on the earlier reforms: an independent Financial Policy Committee (FPC) was created at the Bank that had substantial new powers it could deploy in order to maintain financial stability. At the same time two new financial regulators were created:


Prudential Regulation Authority (PRA): Part of the Bank, it focuses on the approximately 1,700 most systemically important financial institutions, including banks, building societies, credit unions, insurers and investment firms. It monitors and sets how much capital these firms need to hold to ensure that they have sufficient liquidity. Despite their best efforts, financial institutions may still fail. In this case, the PRA works with the Special Resolution Unit to try to limit the fallout.


Financial Conduct Authority (FCA): An independent body and not part of the Bank. Its remit is to prevent financial firms from using dishonest practices as well as ensuring that consumers don’t get ripped off. The FCA is quite different from the FPC and PRA, because it doesn’t focus on issues of systemic risk directly – although arguably, protecting consumers’ interests hopefully means that people have more faith in the financial system as a whole.

The hope is that these reforms will reduce excessive risk taking on the part of financial institutions and thereby reduce the probability of bank bankruptcy (see what we did there?!) and a subsequent financial crisis. Whether the new regulations are indeed ‘smarter’ than the old ones remains to be seen.