NY FED: The US Short Selling Ban During The Financial Crisis Was A Costly Failure

As we’ve seen in Spain and Italy recently, during times of crisis and market stress, regulators turn to short selling restrictions in an attempt to slow sharp declines in certain stock’s value. 

The United States tried it during the 2008 financial crisis, in the aftermath Lehman Brothers filing for bankruptcy protection.

However, in a new report from the New York Fed, Robert Battalio, Hamid Mehran, and Paul Schultz present empirical evidence that the restrictions not only failed to stop plunging prices, they may have actually made things worse.

The United States announced a short selling ban on financial stocks Friday, September 19th. Here’s the authors’ chart of the cumulative returns on stocks subject to and free from the ban:

Short selling ban

Photo: New York Fed

There was a jump in returns in the run up to the ban and on the first trading day, but that may have had more to do with the September 20th submission by the Treasury Department of draft legislation asking for authority to buy troubling assets.

Overall, financial stocks fell 12 per cent over the course of the ban. They stabilised shortly after it was lifted.

The ban fail to arrest price declines and imposed significant additional costs. The paper’s authors estimate that $1 billion in inflated liquidity costs are attributable to the 2008 short selling ban. 

Liquidity costs

Photo: New York Fed

Regulators overestimate the effectiveness of short selling bans, and underestimate their costs. Short sellers attempt to exploit mispriced stocks. Their ability to drive shares below their market value is overestimated, and banning the practice doesn’t arrest price declines.  

Read the full paper here

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