When the latest market squall hit the eurozone last month, the governments of Spain and Italy responded with a time-honored defense; as panic mounted, they banned the short selling of shares in banks, in a desperate bid to shore up confidence.
One month later, it might seem as if this achieved some respite; eurozone stocks have stabilized, as the European Central Bankhas pledged fresh support. But is there any evidence that short-selling bans have any long term effect? Or can they potentially make a bad situation worse?
If a new paper published in a report from the Federal Reserve Bank of New York is correct, the answer is sobering. In recent months, a group of Fed and independent economists have analysed the impact of the short selling ban that was put into place in the US during the financial crisis of 2008, between September 22 and October 8 that year.
Those 2008 conditions are not necessarily identical to those currently prevailing in the rezone. But the conclusions from the research are clear; these economists do not think short selling bans work. For there is precious little evidence that the ban in US markets truly halted share price declines; on the contrary, the impact was (at best) neutral, they claim. However, the ban hurt market mechanisms, as liquidity dried up.
Now, this argument will certainly not sit easily with some politicians. And it is impossible to prove the point — or math — conclusively; after all, nobody will ever know what might have happened to share prices if those short selling bans had not been put into place. However, the Fed paper tries to measure the ban’s impact by tracking what happened to the 995 financial stocks (which were affected by the ban) and non-financial stocks (which were not) between September 22 and October 9, and then comparing this to the pattern before and after the ban. It also looks at another bout of market stress in 2011, when Standard & Poor’s downgraded the US credit rating, and when some stocks were also subject to short-selling restrictions as a result of circuit breakers.
This number-crunching suggests that during the crisis of 2008 those stocks which were subject to a ban rallied when the controls were imposed, but later tumbled, declining more than 12 per cent during the period. This was actually a slightly better performance than for non-financial stocks. But while that might suggest the ban worked, what is perhaps more striking is that those 995 financial stocks actually rallied — not fell — when the ban came to an end.
Thus the Fed paper argues that it was probably not the ban which propped up financial stocks, but the improving policy fundamentals; most notably, during this period, the Troubled asset relief program was being developed, and boosting investor confidence. And this view about the mixed impact of the ban is further reinforced by what happened in 2011; during that period of stress, stocks which were “subject to short-selling restrictions [actually] performed worse than stocks free of such restrictions.”
Of course, fans of market meddling might retort that this ignores another more subtle, but less tangible benefit of the ban; the sight of that intervention might have reassured the public somebody was in control. That, in turn, might have helped to persuade creditors and counterparties to keep dealing with the banks. But there again, by late 2008, it was already clear that the government was willing to backstop the system; Tarp, after all, was in the works. And even if the short-selling ban reassured the public in some senses, it also undermined confidence in others. Most notably, trading liquidity declined sharply, because institutions were no longer able to hedge. Indeed, the Fed calculates that in 2008 alone “the inflated costs of liquidity attributable to the short-sales ban in US equity and options markets are estimated to exceed $1bn.”
Might this persuade the Spanish and Italian leaders to rethink their controls? Don’t hold your breath. After all, there is far more political antipathy towards the markets — and speculators — in the eurozone than in the US; short selling is thus an easy target.
But if nothing else, the Fed paper underscores a crucial point; namely that when a crisis strikes, it is fundamental policy measures that tend to drive bank shares (and investor confidence), not short-term controls. Eurozone leaders would do well to remember that; particularly given their failure, thus far, to produce anything as convincing at that US Tarp plan.