HomeFinanceBanning short selling of regional bank stocks won't solve their problems

Banning short selling of regional bank stocks won’t solve their problems

Proposals to ban short selling of regional bank stocks are a bad idea.

Though banning short selling has appeal to politicians who want to show that they’re doing something, it in fact is the functional equivalent of blaming the messenger for bearing bad news. The core problem that the financial system currently faces is balance-sheet weakness at regional banks, and banning short selling of their stocks does nothing to solve that weakness. In addition, short sale bans have other adverse consequences.

Short selling is a way for investors to bet that a stock’s price is going to fall. Those supporting such bans should study market history. Consider the short sale ban that the SEC imposed in September 2008, four days after the collapse of Lehman Brothers — the largest bankruptcy filing in U.S. history. The ban applied to 799 financial stocks, and then-SEC Chair Christopher Cox said that the ban would “restore equilibrium to markets.”

It didn’t work out that way. In December 2008, three months after the ban went into effect, the Financial Select Sector SPDR ETF

] was 44% lower. (See accompanying chart.) Reflecting on the experience, Cox subsequently said: “Knowing what we know now, I believe on balance the commission [SEC] would not do it [ban short selling of financial stocks] again. The costs appear to outweigh the benefits.”

The costs to which Cox was referring have to do with market quality, things like volatility (which increases in the wake of a short-sale ban), bid-asked spreads (which widen), and liquidity (which falls). Though these costs are diffuse as opposed to concentrated in one stocks or sector, they cumulatively add up to a significant loss.

Matthew Ringgenberg, a finance professor at the University of Utah who researches short selling, said in an interview that academia has extensively studied the impact of the 2008 ban, and has reached the same conclusion Cox did: “The academic research is clear: The 2008 short sales ban hurt market quality and was likely counterproductive.”

Ringgenberg continued: “In the current case, short sellers are not the cause of banks’ problems. In most cases the short sellers are simply reacting to negative fundamental information about bank balance sheets. Banning short selling will not fix bank balance sheets.”

Short sellers are an easy target, and it’s tempting to blame them. But an incorrect analysis will not help you beat the market.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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