Short Selling Bans are a Mistake

On Thursday four European countries – France, Italy, Spain and Belgium – announced temporary bans on short selling of specified financial stocks. These bans are mistakes, as shown by the U.S. experience in 2008; they do not prevent declines in financial stocks, but do impose significant costs on capital markets.

Short selling is basically a bet that a stock’s price will fall over time. The short seller borrows shares of a company to sell at time #1, and returns them at time #2 when they buy those same shares in the open market – hoping that the stock’s price will fall between time #1 and time #2.

Trying to prevent stock prices from falling, the U.S. banned short selling of financial stocks in September 2008. However, the prices of these stocks continued to fall, and the ban was lifted before it was due to end.

During its short life, the ban precluded institutional investors from engaging in legitimate hedging activities in financial stocks. For example, a long-time holder of a high-dividend stock could not short it to protect against price declines while continuing to receive its dividends.

At the same time, the ban reduced the liquidity of financial stocks subject to the ban. The spreads between bids and offers as well as the volatility of these stocks increased dramatically during the ban.

Moreover, the European ban on short selling is worse because it is inconsistent. Most countries in Europe did not participate in the ban, and the four participating countries applied different definitions of financial stocks.

Of course, short selling might cause an artificial drop in a stock’s price. On the other hand, short sellers are sometimes right that a stock’s price is overvalued or based on incorrect financial information provided by the company.

During the U.S. financial crisis, many chief executives complained that their stocks were forced down by short sellers. Yet my analysis of financial stocks during this period comes to a mixed conclusion – short sellers were significant factors in the fall of certain financial institutions, but others were brought down primarily by their own fundamental weaknesses.

To reach an appropriate balance, Germany has the right idea – ban “naked” shorting across the whole of the European Union. Naked shorting means selling shares before actually borrowing them. This encourages speculation and leads to trading falls.

And to be effective, the ban against naked shorting should apply in all European countries. In specific, the ban should be implemented through an EU directive requiring all member countries to adopt similar regulations on naked shorting.

Although each financial crisis has some unique characteristics, there are a few lessons to be learnt from prior crises. Let us not make the same mistake by banning short selling of certain stocks in certain countries for limited time periods.