The short selling bans imposed during the financial crisis didn’t work, and had negative side effects, too, suggests new research from economists at the Federal Reserve Bank of New York.
A new study by New York Fed finds that the bans on short-selling that were imposed during the financial crisis “did little” to stabilize the prices of the affected stocks, and “had the unwanted effects of lowering market liquidity and boosting trading costs”.
The study shows that the restrictions that were imposed at the height of the financial crisis in 2008 did little to slow the decline in the prices of financial stocks. In fact, it finds that prices fell more than 12% over the 14 days in which the ban was in effect. In addition, it estimates that the bans increased trading costs in the equity and options markets by more than $1 billion.
It also looks at the effects of short-selling in August 2011, after Standard and Poor’s announced that it was downgrading the long-term sovereign credit rating of the US. It reports that the S&P 500 fell 6.7% on the first trading day after the downgrade was announced, but says its findings “suggest that short-selling was not a cause of the market’s decline.”
“Indeed, stocks with net short-selling around this time actually had higher returns than other stocks,” it says. And, it reports that stocks that triggered circuit-breaker restrictions, and so could not be shorted on the day the downgrade was announced, had lower returns than the stocks that were eligible for shorting.
And, it says that a statistical exercise conducted to determine the relationship between short-selling and stock returns, “finds that the two variables are minimally correlated”.
“Taken as a whole, our research challenges the notion that banning short sales during market downturns limits share price declines. If anything, the bans seem to have the unwanted effects of raising trading costs, lowering market liquidity, and preventing short-sellers from rooting out cases of fraud and earnings manipulation,” it concludes. “Thus, while short-sellers may bear bad news about companies’ prospects, they do not appear to be driving price declines in markets.”