Belfast Telegraph

Don't ban short-selling, if you know your onions

By Sean O'Grady

When I find a short-seller, I want to tear his heart out and eat it before his eyes while he's still alive." So said Dick 'the Gorilla' Fuld, former boss of Lehman Brothers, before its downfall.

Such sentiments are not confined to bankers under pressure. Now bans on short-selling are being implemented by regulators in France, Italy, Spain and Belgium. They are meant to be confidence-building measures that limit speculators' activities and restore stability - in the current case to bank shares. In practice, they achieve the reverse. Even if short-selling is widespread - and the latest data suggests it is not yet acute for the European banks - a ban would not have much of an impact because the proportion of the banks' equity available for shorting is mostly below 2%. Compare this with 10 to 20% for the UK and US banks under pressure in 2008.

Would a ban on short-selling work? Not really. One celebrated case is the Onion Futures Act of 1958. Passed in the US after some unscrupulous dealers attempted to corner and manipulate the market in onions, it remains on the federal statute book to this day. Thus, if any American tries to sell you an onion for delivery in, say, November, you should contact the US Securities and Exchange Commission.

Economists have had a good deal of fun with the Onion Futures Act and the consensus seems to be that it hasn't made much difference to the onion world, in the long term. Now, banks are (arguably) more important than onions, but the evidence is similar.

A fresh survey of the many studies of the subject, from Cass Business School, concludes that "evidence from 30 countries shows short-selling restrictions fail to support stock prices and reduce market liquidity" and could cause "more harm than good". The authors conclude the bans damaged the ability of capital markets to operate smoothly in the panic of 2007-2008.

They say: "Our evidence convincingly shows that bans are bad for liquidity and do not help to support prices. This should send a strong message to regulators that fresh bans on short-selling could cause more harm than good. The evidence also shows that short-selling bans made stock prices slower in reacting to new information.

"By restraining the trading activity of informed traders with negative information about companies, the ban slowed down the speed at which news fed through to market prices."

But suppose a ban on short-selling a stock could indeed bolster its share price. Is that even desirable?

There is really no good reason to underpin the share price of a bank that is basically bust.

If an institution is judged "too big to fail" and has to be recapitalised by the state, then the shares the state buys will, other things being equal, be more expensive than they would be absent the ban. It is thus a mechanism for transferring wealth from taxpayers to bank shareholders, whose equity, to that extent at least, is artificially underpinned by the ban. It hardly needs pointing out that this is the opposite of the natural order of things - that bank shareholders ought to be wiped out when their institution goes insolvent.

Now the question then arises as to the case of a bank that is suffering temporary liquidity difficulties rather than being outright insolvent. In that case it might be justified to deliver some stability to an institution while it sorts out its cash flow. The trouble is no-one can tell which institutions are illiquid (only) and which are insolvent.

Propping up a share price would only work in a liquidity crisis if the ultimate aim would be to restore liquidity through raising more capital - a somewhat cumbersome method of raising cash at hand. If a slump in a share price triggers a run in a bank, that, too, can and ought to be dealt with in the usual way by a central bank. What went so badly wrong three years ago is that the banks were not just illiquid but insolvent. Their liabilities exceeded their assets.

When a bank analyst points out that the emperor is wearing no clothes - as Meredith Whitney did in 2007 when she slapped a 'sell' on Citi - the bank threatens to sue.

A ban on short-selling suggests that the EU authorities think the problem with the banks and sovereign debt is a lack of liquidity; we all know that it is, again, a matter of solvency.

For that reason, the ban on short-selling is, literally, delusional.

Our evidence convincingly shows that bans are bad for liquidity and do not help to support prices