Do Short-Selling Bans Work?

Whenever markets plummet, investors who sell stocks short get taken out to the woodshed as if they're solely to blame for stocks' woes. Yet securities regulators keep taking the same actions in response to big market downdrafts, even though history has shown them time and time again that they won't work.

The European solution
Earlier this month, France, Spain, Italy, and Belgium all restricted short selling in certain financial stocks. Concerns about the impact that sovereign debt defaults or restructuring could have on European bank balance sheets had put stocks under severe pressure. In particular, French banks Societe Generale, BNP Paribas, and Credit Agricole were the focus of attention. Officials cited the moves as necessary to avoid "destructive speculation" that could bring fragile financial institutions down.

In theory, short-selling bans make plenty of sense. By removing one source of selling pressure for a stock, one would think that a ban would stabilize the stocks. Unfortunately, though, past experience suggests a completely different outcome from limiting short sales.

Looking back to the financial crisis
The problems with short-selling bans stem from two major sources. First, global listings of stocks require coordinated effort in order to make sure short selling stops entirely. For instance, in May 2010, Germany banned short selling in 10 of its financial institutions. Yet because stocks like Deutsche Bank (NYSE: DB) trade not only in Germany but also on the New York Stock Exchange, the failure of U.S. regulators to join in the ban allowed investors to use U.S.-listed shares for short-selling purposes. That same possibility exists in the current ban, as companies like Spanish bank Banco Santander (NYSE: STD) have U.S.-traded ADRs.

But the bigger issue is that short-selling bans don't change the fundamental problems that a company faces. The best they can hope to achieve is to slow down what might otherwise be a panicked selling frenzy, but they certainly won't prevent stock prices from eventually reaching their proper levels.

Two episodes from the 2008 financial crisis provide great examples of this. In July, a temporary short-selling ban protected shares of housing agencies Fannie Mae and Freddie Mac. Yet it was only a short time later that both companies began their quick fall to penny-stock status, from which neither has emerged.

Then, on Sept. 18, regulators banned short sales of financial stocks through Oct. 8. Here, the impact the move had on stock prices pretty much speaks for itself:

Source: Yahoo! Finance. Returns from Sept. 18, 2008 close to Oct. 8, 2008 close.

As you can see, the severity of the credit crisis, which threatened to lock up the entire financial system and eventually necessitated the government's huge TARP bailout plan, provided more than enough fundamental downward pressure to push these stocks down without the help of short-selling.

Whatever will be, will be
Inevitably, after days like yesterday's broad-based stock market rally, some will credit moves like the one that European governments took to ban short selling as having successfully ended the stock market's decline. But over the long run, whether European financial stocks -- and the companies around the world that rely on them as counterparties and facilitators -- can survive and thrive depends not on the willingness of securities regulators to interfere in free market practices, but rather on the strength of their businesses. If banks can't find ways to raise capital to survive hard times, no short-selling ban will do a lick of good to keep share prices up for very long.

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