On 19 September 2008 – just as the failure of Lehman Brothers had shaken investors’ confidence in banks’ solvency and sent stocks into freefall – the US Securities and Exchange Commission (SEC) prohibited “short sales” of financial companies’ stocks. The hope was that this would stem the tide of sales and help support bank stock prices.
The SEC’s move sparked worldwide herding by regulators. In the subsequent weeks and months, most stock exchange regulators around the globe issued bans or regulatory constraints on short selling. Some of the bans were “naked”, i.e. only ruled out sales where the seller does not borrow the stock in time to deliver it to the buyer within the standard settlement period (naked short sales). Other bans were “covered”, ruling out also sales where the seller manages to borrow the stock (covered short sales).
Figure 1 shows the diffusion of short-selling bans across the world during the crisis, by plotting the fraction of banned stocks in a sample of 30 countries. The overall fraction of banned stocks jumps from 0 to about 20% in September 2008, rising to over 30% in October, before gradually decreasing back to 20% over the following eight months.
Figure 1. Fraction of stocks affected by short-selling bans around the world
As of June 2009, about 20% of the stocks worldwide were still subject to naked bans, whereas covered bans had almost disappeared. These hurried interventions, which varied considerably in intensity, scope and duration, were invariably presented as measures to restore the orderly functioning of security markets and limit unwarranted drops in securities prices. Did they achieve their stated purpose? And did they have any negative side effects?
Both theoretical arguments and previous evidence would have advised greater caution. The effectiveness of short-selling bans in supporting stock prices is controversial, and several previous studies alerted that such bans can damage stock market liquidity and slow down the speed at which new information is impounded in stock prices. Since the crisis was accompanied by a widespread and steep increase in bid-ask spreads in stock markets, as shown by Figure 2, it is important to understand whether, and to what extent, short-selling bans contributed to their increase, and therefore reduced stock market liquidity.
Figure 2. Average bid-ask spread around the world (thin line: daily values, bold line: 5-day moving average)
Was the SEC right?
Now that economists have canvassed the evidence about the short-selling bans during the crisis, it is possible to evaluate this policy intervention. Boehmer, Jones and Zhang (2009) have analysed the response of liquidity measures to the short-selling ban imposed by the SEC from September 19 to October 8, exploiting the difference between the financial sector stocks targeted by the ban and those that were not. They have found that liquidity – as measured by spreads and price impacts – deteriorated significantly for stocks subject to the ban.
But did the SEC at least manage to achieve its stated objective, that is, stem the collapse of stock prices? Even this is unclear. Boehmer et al. (2009) document large price increases for banned stocks upon announcement of the ban, followed by gradual decreases during the ban period. Yet they recognise that the correlation with the ban could be spurious, as the prices of US financial stocks could have been affected by the accompanying announcement of the US bank bail-out program – the Troubled Asset Relief Program (TARP). Their scepticism is reinforced by the finding that stocks that were later added to the ban list experienced no positive share price effects. But, Harris, Namvar, and Phillips (2009) try to control for the TARP legislation and find that the positive abnormal returns for banned stocks cannot be explained by a TARP fund index.
Clearly, reliance on data from US markets – where the start of the short-selling ban on financials coincided with bank bailout announcements – makes it hard to identify the price effects of the ban. International evidence can be valuable in this respect, since in several other countries short-selling bans were not accompanied by bank bailout announcements. Moreover, in many countries bans also applied to non-financial stocks, and in other countries financial stocks were simply not banned.
New evidence from a worldwide policy experiment
In a recent paper (Beber and Pagano 2009), we harness the large amount of evidence that short-selling bans have generated during the crisis, relying on cross-country as well as time-series variation in the scope, intensity and duration of the bans. Short-selling restrictions were imposed and lifted at different dates in different countries. They often applied to different sets of stocks (only financials in some countries, all stocks in others) and featured different degrees of stringency. All these features make the data ideally suited to identify the effects of the bans through panel data techniques.
We assemble a set of daily data for nearly 17,000 stocks from 30 countries, for the period spanning from January 2008 to June 2009. Our analysis controls for time-invariant stock characteristics, as well as for return volatility and for common risk factors. The latter controls are important, since during the crisis increased uncertainty and acute funding problems are likely to have affected stock market liquidity throughout the world. Our results indicate that the bans have not been associated with better stock price performance, the US being the exception. The most immediate evidence on this point is obtained by comparing post-ban median cumulative excess returns – with respect to market indices – for stocks subject to bans with those of exempt stocks.
Figure 3 shows that the median cumulative excess return of US financial stocks, which were subjected to a covered ban, exceeded that of exempt stocks throughout the 14 trading days after the ban inception (date 0 in the figure), a finding that agrees with that reported by Boehmer et al. (2009). But, Figure 4 shows that this is not the case for the other countries in our sample: the line corresponding to the median excess return on stocks subject to naked and covered bans is very close to that for exempt stocks, and it lies above it only in about half of the first 60 days of trading after the inception of the ban. Since the confounding factor of simultaneous policy measures in support of financial institutions is not present in all the other countries that imposed a short-selling ban on financials, Figure 4 is likely to convey a more accurate picture of the effects of short-selling bans on stock returns than Figure 3.
Figure 3. Cumulative abnormal returns over 14 trading days after ban date in the US
Figure 4. Cumulative abnormal returns over 60 trading days after ban date in countries with ban on financials only (except the US)
This conclusion is confirmed and actually reinforced by the econometric analysis. When we use our entire data set, bans on covered short sales turn out to be correlated with significantly lower excess returns relative to stocks unaffected by the ban, while bans on naked sales and disclosure obligation do not have a significant correlation with excess returns. When one looks at countries with short-selling bans on financials only, bans turn out to be correlated with positive excess returns only for the US, not for other countries. But, as noted above, the positive correlation for the US may be spurious.
In contrast to the regulators’ hopes, therefore, the overall evidence indicates that short-selling bans have at best left stock prices unaffected, and at worst may have contributed to their decline.
Moreover, we find that short-selling bans imposed during the crisis had unintended but important negative consequences on liquidity and price discovery. Our results indicate that the bans are associated with a statistically and economically significant increase in bid-ask spreads throughout the world. In contrast, the obligation to disclose short sales is associated with a significant decrease in bid-ask spreads. We also find that the negative effects of short-selling bans on liquidity are more pronounced for small-cap and more volatile stocks. As a result, in countries where such stocks are overrepresented, the bans are associated with larger increases in bid-ask spreads. This is illustrated in Figure 5, which shows the magnitude of the bans’ effects in different countries, separately for the naked and the covered bans. Italy emerges as the country where the ban on short sales was associated with the most dramatic deterioration of market liquidity, followed by Denmark, Australia and Norway. The US, UK and Ireland are in an intermediate group, while in the remaining countries short-selling bans have been associated with comparatively mild increases in bid-ask spreads.
Figure 5. Impact of short-selling ban on the quoted bid-ask spread
Note: Bars estimated coefficient of naked or covered ban based on Table 6 in Beber and Pagano (2009)
The evidence also shows that short-selling bans made stock returns more correlated with their own past values, that is, made stock prices slower in reacting to new information. This slowdown in price discovery, especially when negative news are concerned, is in line with the findings of previous empirical studies, for instance Bris and Goetzmann (2007), and with the predictions of the theory. By restraining the trading activity of informed traders with negative information about fundamentals, a short-selling ban slows down the speed at which news are impounded in market prices, and more so in bear market phases.
The evidence suggests that the knee-jerk reaction of most stock exchange regulators around the globe to the financial crisis – imposing bans or regulatory constraints on short-selling – was at best neutral in its effects on stock prices. The impact on market liquidity was clearly detrimental, especially for small-cap and high-risk stocks. Moreover, it slowed down price discovery.
Perhaps the main social payoff of this worldwide policy experiment has been that of generating a large amount of evidence about the effects of short-selling bans. The conclusion suggested by this evidence is best summarised by the words of the former SEC Chairman Christopher Cox on 31 December 2008: “Knowing what we know now, [we] would not do it again. The costs appear to outweigh the benefits”. We hope that this lesson will be remembered when security markets face the next crisis.
Beber, Alessandro and Marco Pagano (2009), “Short-Selling Bans around the World: Evidence from the 2007-09 Crisis”, CEPR Discussion Paper 7557.
Boehmer, Ekkehart, Charles M. Jones and Xiaoyan Zhang (2009), “Shackling Short Sellers: The 2008 Shorting Ban”, Columbia Business School, unpublished manuscript, September.
Bris, Arturo, William N. Goetzmann, and Ning Zhu (2007), “Efficiency and the Bear: Short Sales and Markets around the World”, Journal of Finance 62(3):1029-1079.
Harris, Lawrence E, Ethan Namvar, and Blake Phillips (2009), “Price Inflation and Wealth Transfer during the 2008 SEC Short-Sale Ban”, June, unpublished manuscript.