Short-selling bans: When emotion trumps good policy

Sometimes we are emphatic we must treat the symptoms of a problem, rather than then illness. One good case is short-selling bans – we say that people can’t benefit from falls in a company’s share price, right at the time when we are worried about shares in a companies share-price.

From the Economist, a while ago:

This week the European Union also agreed to ban “naked” shorting of shares (when stocks have not been borrowed before they are sold) and naked purchases of sovereign credit-default swaps (CDSs), whereby investors buy protection without owning the underlying bonds.

Almost all research I’ve seen on short-selling bans indicates they are a bad idea (naked or not), and a forthcoming article by in the Journal of Finance reinforces that opinion:

Most regulators around the world reacted to the 2007-09 crisis by imposing bans or constraints on short-selling. These were imposed and lifted at different dates in different countries, often applied to different sets of stocks and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed down price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.

What are the benefits of short-selling bans? For a short period of time, usually about a month, the companies’ shares rebound, simply due to short-sellers having to unravel their position. I’m not aware of any study which shows any long-term benefit, honestly. I’d be happy to be proven wrong if I’m being ignorant, but I’m drawing a blank.

So if there is so little evidence of the benefits of short-selling bans, why do politicians come back to them all the time?

I see a couple of potential reasons, all psychological, rather than practical:

  • Ickiness”: the distaste of the idea that someone benefits when someone else fails.
  • Perceived mis-incentives: If short-selling could cause an otherwise good company to lose value, we wouldn’t want to give people incentive to cause them to fail. But shorting itself can’t – short-sellers need long-buyers to sell to, and both parties believe they are right. But we are still averse to incentivizing negative positions.

A politician looking to score easy points will gravitate to perpetuating these views, even when they are wrong. They imply that nasty “speculators” are causing harm, and that bans  prevent speculators from benefiting when we, the good investors, are losing. It’s a win-win situation for them, and explaining the actual functioning of short-selling isn’t really a sound-bite argument.

This is clearly a case of behavioral finance influencing financial policy, and not even in a progressive/redistributive way. In this case, regulators and politicians make a decision based on emotion rather than fact. The fact is that short-selling bans can often cause exactly the sort of problems they are trying to prevent. But they, and we don’t care because it feels right to say it shouldn’t happen.

But this  medicine is worse than the illness.

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