Bans on short-selling imposed during the financial crisis in the belief that short sales were driving United States stock prices below fundamental values did little to stabilize those prices, according to a new study by New York Fed economists. In addition, the bans had the unwanted effects of lowering market liquidity and boosting trading costs.
In "Market Declines: What Is Accomplished by Banning Short-Selling?" New York Fed economist Hamid Mehran and Notre Dame finance professors Robert Battalio and Paul Schultz investigate the link between short-selling and market downturns. The authors first evaluate evidence on the bans’ effectiveness in limiting share price declines in 2008. To provide additional evidence, the three then consider the market effects of short-selling in August 2011, when the debt-rating agency Standard and Poor’s lowered the U.S. sovereign long-term credit rating, prompting the S&P 500 to fall 6.66 percent on the next trading day. At the time, there was no short-selling ban in place in the U.S.
Short-selling entails borrowing shares and then selling them in the expectation that they can be repurchased later at a lower price. Although the practice is common, concerns have arisen that short-selling drives stock prices to artificially low levels. For that reason, U.S. regulators banned the short-selling of financial stocks during the 2008-09 crisis and have selectively applied restrictions on short sales at other times.
In their study, the authors review existing research and conduct new analysis to show that the 2008 restrictions did little to slow the decline in the prices of financial stocks; in fact, prices fell more than 12 percent over the fourteen days in which the ban was in effect. In addition, the authors calculate that the bans increased trading costs in the equity and options markets by more than $1 billion. Moreover, the authors uncover no evidence that stock prices declined following the downgrade of the U.S. credit rating as a result of short-selling. A statistical exercise conducted to determine the relationship between short-selling and stock returns finds that the two variables are minimally correlated.
The study can be read in full in the latest Current Issues in Economics and Finance.