Shorting bans don’t work: research

Banning short selling during market downturns doesn’t work, says new research by the Federal Reserve Bank of New York.

In a new paper, entitled “Market Declines: Is banning short selling the solution”, economist Hamid Mehran—along with two University of Notre Dame finance professors—look at how global regulators limited selling activity in 2011, and whether or not prohibiting short selling is worth the time and effort.

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Scores of European officials banned shorting in 2011 in response to rampant debt problems, they say, and “The U.S. was under pressure to follow suit.”

“There are many unresolved questions concerning short selling, short selling bans, and ad hoc short selling bans in particular,” say the researchers. “Should the U.S. have also banned short selling in August 2011? [We wrote this paper] to examine the link between market declines and short selling, and to consider its potential benefits and costs vis-à-vis the real economy.”

Short sellers claim that by identifying overvalued stocks and correcting the mispricing, they provide an invaluable service to investors, says the paper.

But—after analyzing 2008 and 2009 markets—the group claims banning does little to neutralize pricing risks; “in the U.S., stocks generated positive abnormal returns (relative to the market) during shorting bans. However, this was largely due to legislative efforts that supported financial institutions during that period, rather than the bans.”

The group concludes trading bans during that period didn’t boost markets; their collective effect on stock prices was neutral at best.

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Their final words: “While short sellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in markets.”

Wall Street Journal contributor Neal Lipschutz agrees; in a recent blog post, he said the conclusions “[won’t] seem like shocking news to those who believe market forces have to play themselves out, even in volatile times. Same goes for those who can distinguish between the impact of short selling, the borrowing of shares to sell later at a lower price, and flat-out selling.”

Yet, the banning goes on, with Italy and Spain having disallowed short selling temporarily just last month.

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