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A Bad Ban

Friday, September 2, 2011

France, Italy, Spain, and Belgium have implemented short selling bans on their financial stocks. It’s a bad idea that will lead to more trouble down the road.

“Knowing what we know now, I believe on balance the Commission would not do it again. The costs appear to outweigh the benefits,” said Christopher Cox on banning the short selling of financial stocks. The former Securities and Exchange Commission (SEC) chairman was speaking on December 30, 2008, three months after the implementation of a temporary ban on short selling.

Yet, on August 12, France, Italy, Spain, and Belgium implemented similar short selling bans on their financial stocks. Moreover, European regulators recently decided to extend these bans beyond their initial 15-day term. Belgium began with an indefinite ban and is retaining it.

The bans should not have been extended, and they must not be maintained. Short selling is being scapegoated by politicians, and history indicates that short selling bans badly damage markets by inflating stock prices, reducing liquidity, and increasing volatility. In addition, once in place, there are few legal limits on how long these bans may be prolonged.

Short selling is a tool used by bearish investors who bet that a stock’s price will fall. A short seller borrows shares of a company’s stock and sells them. If the price declines, the loan can be repaid by buying back shares for less. Ideally, a short seller sells high and then buys low.

When markets turn south, short sellers are often blamed because they can theoretically manipulate markets and drive prices down. If a company’s share price is seen as affecting the underlying economics of the business, a feedback loop is created wherein lower share prices mean worse fundamentals, and worse fundamentals depress share prices.

Short selling is being scapegoated by politicians, and history indicates that short selling bans badly damage markets by inflating stock prices, reducing liquidity, and increasing volatility.

Bank stocks are particularly vulnerable since their balance sheets tend to be quite sensitive, and a plummeting share price saps balance sheet strength. But market manipulation is not the only reason a bank’s stock might underperform. The company’s fundamentals may be weak independent of manipulation, or the economic outlook might be bad. While short selling bans are designed to restrain manipulation, they won’t heal a wounded company or cure a sick economy.

Was there evidence of rampant shorting in the French, Spanish, Italian, and Belgian financial sectors leading up to the ban? Not really. Data Explorers, a securities analytics firm, studied  the average percent of shares on loan, a proxy for short-selling activity, and a measure which would have most likely shown a spike if short sellers were trying to manipulate the markets and drive prices down.

That’s not what they found. Instead, from January 2011 through August 2011 in France and Italy, the percent of shares on loan was much lower for the financial stocks affected by the ban than for other stocks. Furthermore, in the last couple of weeks before the ban was implemented, there was only a slight uptick. In Belgium and Spain, the picture is hazier, but the percent of shares on loan was not any higher before the ban than it has been frequently throughout the year. No smoking, market-manipulating, gun was found.

However, it is possible that “naked” short sellers, who do not borrow a share before selling it, might be manipulating the markets. Their activities would not show up in the percent of shares on loan. To deal with this possibility, regulators should heed Germany’s call to ban the naked short selling of stocks across the Eurozone instead of banning all short selling.

Regulators should heed Germany’s call to ban the naked short selling of stocks across the Eurozone instead of banning all short selling.

We know how damaging short selling bans are precisely because of the follies committed by the SEC and regulators around the world in response to the 2008 financial crisis. The data gleaned from those bans proves what traders have always known: short selling bans hurt markets and the economy.

For one, short selling bans can inflate stock prices. While bans are in effect, only investors that already own stock can express bearish views by selling, but anyone can express bullish views by buying. Uninformed optimists don’t account for the fact that pessimists are shut out of the market. The absence of pessimists also slows down the market’s reaction to negative information.

In their study, economists Lawrence Harris, Ethan Namvar, and Blake Phillips found substantial price inflation during the 2008 SEC short selling ban, particularly for stocks that had been falling prior to the ban. This effect might explain some of the price increases for European bank shares the day that the European bans took effect.

But price inflation is only good for politicians—they look bad when share prices tank and great when government action is followed by market rallies. In the United States, prices returned to normal after the bans were lifted. This amounted to a large transfer of wealth from uninformed investors, who bought during the ban, to informed investors, who sold knowing that prices would soon fall when the ban ended.

Short selling bans severely degrade liquidity and increase volatility.

A second effect of short selling bans is to severely degrade liquidity and increase volatility. Economists Ekkehart Boehmer, Charles Jones, and Xiaoyan Zhang found that during the 2008 SEC ban, bid-ask spreads widened significantly. Along with price inflation, this contributes to a gross misallocation of capital. When liquidity is low, investors face large costs for buying and selling shares, and capital is impeded from flowing to its most efficient use.

European regulators succumbed to temptation and extended the short selling bans in a quixotic attempt to fix the markets. It was a grave mistake, and it is imperative that they do not retain these bans into perpetuity. The European economy is struggling, and their contagion is largely driving recent volatility in U.S. markets. Short-selling bans breed inefficiency and will exacerbate the problem. Markets across the world will suffer if these European countries continue to compound their mistakes before they begin to regret them.

Matthew Jensen is an economics research assistant at the American Enterprise Institute.

FURTHER READING: Jensen and Andrew Biggs coauthor “Yes, You Really Can Cut Your Way to Prosperity.” Jensen, Biggs, and Kevin Hassett give “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked.” Arnold Kling writes “Putting Mr. Market on the Couch.”

Image by Rob Green | Bergman Group

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