In both the subprime crisis and the euro-area crisis, regulators imposed bans on short sales, aimed mainly at preventing stock price turbulence from destabilizing financial institutions. Contrary to the regulators’ intentions, financial institutions whose stocks were banned experienced greater increases in the probability of default and volatility than unbanned ones, and these increases were larger for more vulnerable financial institutions. To take into account the endogeneity of short sales bans, researchers from the European Systemic Risk Board (ESRB) match banned financial institutions with unbanned ones of similar size and riskiness, and instrument the 2011 ban decisions with regulators’ propensity to impose a ban in the 2008 crisis.
Evidence indicates that short-selling bans are not associated with greater bank stability. In fact, our estimates, even controlling for the endogeneity of the bans, point to the opposite result, namely that bans on short sales tend to be correlated with higher probability of default, greater return volatility and steeper stock price declines, particularly for banks. The market may have read the imposition of bans as a signal that regulators were in possession of more strongly negative information about the solvency of companies, and especially banks, than was available to the public.