Few things are more predictable than loud demands for regulatory interventions to ‘stop speculation’ when stock market prices plunge: in these days, as in any recent stock market crash, we hear politicians and commentators inviting regulators to enact interventions spanning from stock trading suspension to a short sales ban. In the past, stock market regulators typically bowed to such demands: banning short sales is almost their ‘Pavlovian response’ when faced with widespread drop in stock market prices.
Over the last twenty years, unfortunately there has been no shortage of crises, so that we have had the opportunity to observe this ‘Pavlovian response’ of regulators repeatedly and in many countries. On September 19, 2008, immediately after the Lehman collapse shook investors’ confidence in the soundness of banks and brought down the prices of their shares, the Securities and Exchange Commission (SEC) banned short selling of shares in banks and financial companies in the US. This ban was quickly imitated by the majority of other countries: some only banned ‘naked short sales’, in which the seller does not borrow shares to deliver them to the buyer during the settlement period; others also banned covered short sales, in which the seller protects himself by borrowing the shares. More recently, during the sovereign debt crisis of 2011-12, regulators in most eurozone countries have reacted in the same way to share prices drops, especially those in the banking sector.
These hasty interventions, while varying from country to country in intensity, scope and duration, were invariably presented as aimed at restoring the orderly functioning of the markets and avoiding unwarranted drops in stock prices, and their destabilizing effects. For example, in 2008 the SEC justified its intervention with these words: ‘unbridled short selling is contributing to the recent sudden price declines in the securities of financial institutions unrelated to true price valuation’. In the UK, the Financial Services Authority motivated the short-selling ban it introduced on 18 September 2008 for financial stocks as follows: ‘sharp share price declines in individual banks were likely to lead to pressure on their funding and thus create a self-fulfilling loop’. Similarly, in 2012 the Spanish stock market regulator (CNMV) explained its decision to retain the ban introduced in 2011 arguing that ‘failure to ban short sales would heighten uncertainty’, and that accordingly keeping the ban was ‘absolutely necessary to ensure the stability of the Spanish financial system and capital markets’. In short, the conditioned reflex of the regulator rests on this argument: in times of crisis, stock prices fall below their ‘true valuation’, which can destabilize banks and therefore the financial system; by prohibiting short selling, we prevent too pessimistic investors from ‘expressing their opinions’ on the market regarding the value of the shares, hence we avoid the destabilizing undervaluation that would follow.
While apparently sensible, this argument has serious flaws, both in principle and in fact. First, the argument assumes that regulators know better than the market what the ‘true valuation’ of securities is, better than the thousands of investors who spend huge resources every day to also try to calculate such true valuations, so as to buy undervalued securities and sell overvalued ones. But if so, why don’t the authorities that oversee security markets intervene even when prices rise above ‘true valuations’, before the market crashes? If we ban short sales to prevent unwarranted price drops, we should symmetrically ban ‘excessive’ purchases leading to unwarranted security market booms!
Second, the empirical evidence that has accumulated over the years, especially in the last two decades, shows that the ban on short selling is neither able to support security prices, nor to make banks more stable. In a study published with Alessandro Beber in the Journal of Finance in 2013, we analyzed daily data on 16,491 shares in 30 countries between January 2008 and June 2009. Our results indicate that the short-selling bans implemented over those months did not go hand in hand with increases or lower drops in the prices of exchange, except in the United States in the two weeks following the application of the ban, an exception probably due to the simultaneous announcement of bank bailouts by the United States government. In other countries, where the bans were not accompanied by announcements of bank bailouts, or also targeted non-bank shares, or did not target bank shares at all, the ban on short selling does not seem to have supported security prices. The estimates indicate that banning naked short sales did not have significant effects on share prices, and banning covered short sales even made them decrease! A subsequent work carried out with Alessandro Beber, Daniela Fabbri and Saverio Simonelli in 2018 also shows that, contrary to what expected by regulators, banks whose securities were subject to short-selling bans even featured an increased probability of insolvency, compared to other banks featuring similar risk and size but exempt from the ban.
Third, the empirical analysis shows that short-selling bans have significant negative ‘side effects’. They tend to considerably reduce the liquidity of the markets, because they are accompanied by an increase in bid-ask spreads, especially for smaller companies: reducing market liquidity is particularly damaging in crisis conditions, when liquidity is already in short supply and investors seek it desperately. Furthermore, these bans substantially reduce the information efficiency of security markets, that is, the speed with which new information is impounded in prices: trying to ‘silence the pessimists’ makes everyone less informed and thus increases market uncertainty!
The conclusion suggested by the evidence is therefore well summarized by the words pronounced on 31 December 2008 by the former president of the SEC, Christopher Cox: ‘Knowing what we know now, I believe on balance the commission would not do it again. The costs (of the short-selling ban on financials) appear to outweigh the benefits.’ Hopefully, supervisors around the world will remember this lesson now that they are facing a new financial crisis.
This post is the translation of an op-ed published in the Italian daily il Foglio and available (behind paywall) here.
Marco Pagano is Full Professor of Finance at the University of Naples Federico II and Director, Centre for Studies in Economics and Finance.