Sean O'Grady: A short-selling ban is short-sighted and could do more harm than good

Economic View

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The Independent Online

'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 per cent. Compare this with 10 to 20 per cent 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: "The fall in liquidity was particularly dangerous because it came at a time when bid-ask spreads were already high as a result of the crisis, and investors were desperately seeking liquid security markets due to the freeze of many fixed-income markets.

"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."

They certainly didn't save any banks from collapse, as the banks' problems were, as we can now see, all too real and not the product of some outlandish malicious rumour. Indeed, the truth about the global financial system was far more horrific than any fantasist could have predicted.

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 insolvent – illiquidity itself can be a symptom of either. Besides, much the best way to deal with a liquidity crisis is via the usual battery of weapons in the central banks' armouries – short-term loans or longer-term assistance on appropriate terms and conditions.

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 actually insolvent. Their liabilities exceeded their assets; their lack of immediate access to funds was merely a symptom, not a cause, of the problem. To sum up, we could end all trading in all shares of bank X, but if bank X is overleveraged and busted, that will not save it.

It all falls into a pattern the authorities seem to have developed, which can be basically summarised as "shoot the messenger". If the markets mark down shares of a dodgy bank, then shut the market. If the credit ratings agencies make some disobliging remarks about a country or downgrade its debt, governments bully them into submission and publicly rubbish their (admittedly mixed) record. 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. Instead of wasting time messing about with markets, the European authorities would do far better working out ways to attack the basic flaws in the design of the eurozone and make urgently needed contingency plans to recapitalise large, systemically important, complex, cross-border distressed banks.

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.

'Alarming' images drive up the cost of the riots

What is the long-term economic impact of the riots? One disturbing clue was offered last week by a senior Tata figure.

Ralf Speth, Jaguar Land Rover's chief executive, said on Thursday that he was alarmed by "some of the pictures coming out of the UK". He added that he had never expected to see riots sweep the country. He is not alone.

It was especially poignant, in this context, that one of the minor centres of trouble was Wolverhampton, where Jaguar Land Rover (JLR) proposes to build a new engine plant. Think of that: a new automotive factory in the UK in 2011 – something few of us believed still possible. It will create about 1,000 highly paid quality jobs and push £500m of investment into the UK. The engines will wind up in JLR cars exported across the world. It is deeply symbolic of the economic "rebalancing" we all wish to see.

If I were Tata, I wouldn't want to believe there was even the faintest risk that my new factory could be razed to the ground by arsonists. As with a car brand, the image of a nation is a precious asset.