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Short-Selling Bans and Contagion Risk

Journal 35: Zicklin-Capco Institute Paper Series in Applied Finance

Amelia Pais, Philip A. Stork

Starting in September 2008 stock market regulators across the world introduced, at different times and for different durations, bans on short-selling financial institution’s shares. The argument for the bans is that short selling increases the volatility and contagion risk of financial institutions. This paper uses Extreme Value Theory to calculate univariate and contagion risks across financial institutions, and the effect of short selling on those risks in banks in Belgium, France, Italy and Spain. We find that changes in these downside risk metrics are positively related to changes in short-selling positions.

Since the beginning of the Global Financial Crisis (GFC), regulators around the world have expressed concern about the downward price spirals that can be created by short sellers trading financial institutions’ stocks, and the possibility of increased contagion or systemic risk. Regulators consider the problems associated with systemic risk in the banking industry because the stability of the industry rests on public confidence and because it can be at risk of “panic runs”. Such runs on banks can happen very quickly, and asymmetric information which prevents investors from separating good and bad banks means that there is a higher degree of contagion or systemic risk in the financial industry.

One of the main characteristics of the current GFC has been that bank runs have mostly occurred on wholesale markets, specially short-term debt markets where banks have borrowed heavily, because of the uncertainty about banks’ credit quality as the subprime and sovereign debt crises unfolded. Examples include the “runs” on the repo market, commercial paper market, asset-backed commercial paper market and the money market funds [Gorton and Metrick (2011)]. Their severity prompted central banks globally to successive injections of liquidity, and in some cases to extend deposit guarantees to banks’ wholesale borrowing.

Equity markets are usually regarded as perfectly competitive and regulation around the world is heavily influenced by the efficient market hypothesis, which asserts that asset prices are efficient. It is assumed that competition among investors will ensure that prices continuously adjust to reflect all publicly available information. Therefore, the market as a whole decides if a firm will fail or succeed because prices will reflect the expectations of the whole market about the discounted value of firms’ future cash flows. In this setting, academics and regulators mostly agree that short sellers, as informed traders, perform a valuable role because they are able to identify overvalued securities. Short selling is based on the idea that securities are fungible; an investor can make a profit by selling today a security he has borrowed, and return an identical security to the lender at a later time after buying it cheaper in the market. As an informed trader, the short seller would identify an overvalued security likely to experience negative returns on the future and short it. Short selling improves the dissemination of information about stocks, it enhances the price discovery process, and as consequence markets are more liquid and less volatile.

Short selling is generally permitted around the world. However, the spreading of misleading rumors aimed at driving down the price of shorted stocks, or the use of trading strategies aimed at “pummeling” stock prices and creating panic in long-positions’ holders, are illegal. The alleged market manipulation of financial institutions’ stocks and the downward spiral of prices driven by short sellers has been the core argument for the short selling bans of the GFC.

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