Using data from fourteen equity markets, this study empirically examines the impact of the 2008 short-selling bans on market quality. Evidence indicates that restrictions on short-selling lead to artificially inflated prices, indicated by positive abnormal returns. This is consistent with Miller's (1977) overvaluation theory, and suggests that the bans are effective in temporarily stabilizing prices in struggling financial stocks. Market quality is reduced during the restrictions, as evidenced by wider bid-ask spreads, increased price volatility and reduced trading activity. While these effects are strong, regulators may view the deterioration in market quality as a necessary by-product of the bans to maintain prices and protect investors.
Beginning on September 14, 2008 with the bankruptcy of Lehman Brothers, the global financial crisis entered a new phase marked by the failure of prominent American and European banks. Globally, governments responded by announcing drastic rescue plans for distressed financial institutions. As the financial crisis worsened and with share prices falling sharply, financial market regulators turned to a familiar scapegoat, imposing tight new restrictions on the short-selling of financial stocks. The restrictions commenced on September 19, 2008, with regulators in the United Kingdom banning short-selling (both covered and naked)1 on leading financial stocks. On the same day the Securities and Exchange Commission (SEC) announced a ban on the short-selling on financial stocks effective September 22, 2008 until October 9, 2008. Other markets soon followed and announced their own bans: Australia and Korea banning short-selling on all stocks; Canada, Norway, Ireland, Denmark, Russia, Pakistan and Greece banning short-selling on leading financial stocks; France, Italy, Portugal, Luxembourg, The Netherlands, Austria and Belgium banning naked short-selling on leading financial stocks; and Japan banning naked short-selling on all stocks (see Appendix and Table A-1 for details of changes worldwide).
The view of regulators is homogenous with respect to the rationale behind the restrictions. For example the Financial Services Authority (FSA) CEO Hector Sants notes that action was taken to “protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector”.2 Callum McCarthy, Chairman of the FSA, notes “(T)here is a danger in a trading system which allows financial institutions to be targeted and subject to extreme short-selling pressures, because movements in equity prices can be translated into uncertainty in the minds of those who place deposits with those institutions with consequent financial stability issues. It (the short-selling ban) is designed to have a calming effect — something which the equity markets for financial firms badly need.”3 The SEC had similar concerns noting “Recent market conditions have made us concerned that short-selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets”.4 Overall the comments of regulators suggest that the bans are intended to maintain fair and orderly markets by preventing speculators from placing excessive downward pressure on troubled financial firms.
The purpose of this study is to empirically examine the impact of the 2008 short-selling bans on the market quality of stocks subject to the bans. Thus, in doing so we also examine whether short-selling bans achieve their desired outcome. We use data from fourteen equity markets around the world to examine market quality in terms of abnormal returns, stock price volatility, bid-ask spreads and trading volume. To control for market wide factors or different shocks affecting the market, we compare banned stocks to a group of non-banned stocks. We also examine statistics for similar stocks in markets where short-selling restrictions were not imposed. While short-selling is a contentious issue (see Chancellor, 2001), relatively little or no empirical evidence is available on the impact of short-sale restrictions on market quality. The 2008 short-sale bans provide an ideal setting for these tests because it provides a binding constraint. Thus, we do not rely on proxies for short-sale constraints, as in previous research.
While the results of this study can be used to assess the effectiveness of the short-sales bans on market quality during the financial crisis in which they were imposed, the findings in this study can have much wider reaching implications. By their nature, financial crises and other significant market events cannot be predicted. As events of this nature unfold in the future, market operators and regulators will again be called upon to intervene. Providing evidence of how previous intervention affected markets (and possibly the shortcomings of such intervention) will hopefully provide these market operators and regulators with a more complete knowledge set for future decisions.
The remainder of this paper is organized as follows. Section 2 reviews the literature on short-sale constraints and Section 3 develops a set of testable hypotheses. Section 4 describes the data and methodology used in this study. Section 5 reports the empirical analysis of the impact of the bans on returns, liquidity and stock price volatility. Section 6 provides a summary of the main results and conclusions.
