The financial regulator blamed 'shorting' for disorderly markets and banned it. But Cass research suggests the decision was political and may have made matters worse, writes Sean Farrell.
Dick Fuld, former Chief Executive of Lehman Brothers, didn't mince his words during the death throes of the global investment bank. As the share price plunged in September 2008, he uttered one of the choicest quotes from the financial crisis: "When I find a short seller, I want to tear his heart out and eat it before his eyes while he's still alive."
Mr Fuld's graphic view reflected a wider belief that short sellers were making the crisis worse by preying on fragile banking stocks. Lord Stevenson, the Chairman of HBOS until its merger with Lloyds TSB, said when his company's shares slumped: "We need to be able to stop this modern form of bank robbery." Short sellers usually borrow shares from another investor and sell them with the aim of buying them back more cheaply when the time comes to return them to their rightful owner. Alternatively, some practise "naked shorting" - selling shares they don't hold and gambling on the price falling so that they can buy them back more cheaply before they have to deliver them to the buyer.
Driving down prices
The practice has always aroused suspicion because betting against a company's shares goes against the common perception that rising equity prices are good. In the turbulent markets of late 2008 short sellers were accused of deliberately driving down bank share prices to the point of financial collapse so that they could make a profit. On 18 September 2008, the UK Financial Services Authority (FSA), acting with regulators in the US and other markets, announced a ban on short selling shares in 32 British financial companies. The regulator said it was acting to protect market integrity and guard against further instability in the financial sector. However, Ian Marsh, Professor of Finance at Cass, and Richard Payne, Reader in Finance, examined the full trading data for all shares on the London Stock Exchange* and found no good reason for introducing the ban and no subsequent improvement in market conditions. The FSA said markets had become disorderly, with incoherent trading of financial stocks. However, trading data showed there was nothing extraordinary about conditions for financial stocks before the ban. Market quality indicators worsened in late August and early September and share prices fell sharply as traders sold aggressively, but conditions were similar for financial and non-financial stocks. After the ban, liquidity reduced for financials while transaction costs rose and trading volumes fell - more so than for non-financial companies.
The regulator made its decision as markets entered meltdown following the bankruptcy of Lehman Brothers three days earlier. In particular, the share price of HBOS was under extreme pressure following the announcement of the bank's emergency takeover by Lloyds TSB. The FSA's Chairman at the time, Sir Callum McCarthy, said: "There 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." Sir Callum's reference to the targeting of financial stocks shows the regulator suspected short sellers were driving down prices in a self-fulfilling way - possibly combining their predatory behaviour with malicious rumour mongering. Short sellers had already been blamed for the failure of an HBOS rights issue in July. Professor Marsh and Dr Payne found no evidence of predatory trading by short sellers. They argue traditional long sellers may well have been the real drivers of falling shares and that the ban did nothing to stop the downward path of bank stocks. Dr Payne says: "Given the negative information on prospects for some of these financial institutions at the time, it might well have been entirely rational for long-only funds to decide to go underweight and sell some equity."
In a discussion paper published after the ban lapsed on 16 January 2009, the FSA reiterated its general position that short selling is good for markets in normal times because it builds negative information into prices. But it said that markets were so disrupted in autumn 2008 that shorting was becoming a malignant force. The FSA argued that short selling can become self reinforcing because, in panicky markets, the sale of a large number of shares in a company can drive the price lower than would otherwise be the case. The regulator added that this self-fulfilling aspect was even greater for banks because a falling share price can unnerve the retail and wholesale depositors on whom banks rely to stay in business. The FSA also feared a domino effect, with sharp price falls in some institutions' shares setting off fears about others in the sector, or even more widely. "It was our view that market conditions in the autumn of last year led to a heightened [and unacceptable] risk of abusive behaviour and resultant disorderly markets through short selling, which had the risk of being self fulfilling through the impact on financial institutions' funding mechanisms." Professor Marsh and Dr Payne argue that markets became more disorderly after the ban because the reduction in liquidity led to trades having a greater impact on prices and to a less informative trading process. Trading also shifted from investors placing buy and sell orders on the public limit order book to the less transparent direct trading between dealers - a result unlikely to have been desired by the FSA.
Willingness to act
These were, of course, extraordinary conditions that none of the decision makers had experienced before. Faced with what it believed were chaotic markets, the FSA was under pressure to assert its authority, and targeting short sellers was a way of demonstrating its willingness to act. Alan Yarrow, Chairman of the Chartered Institute for Securities and Investment, says: "We've got no problem with shorting. It can be a way of getting the real value of the share reflected in the marketplace more quickly, which must be a good thing. But if you have got hysteria in a market it is reasonable for any regulator to say: 'It is time out û we are going to consider the position, slow down the trade and see what is going on here.' It was like a circuit breaker û the regulator sometimes has to be seen to be taking the initiative." However, the Cass academics argue that even if markets were in a state of hysteria there was no particular reason for singling out short selling to restore order. Dr Payne says: "Banning short selling is not the only way of putting the brakes on trading in a volatile market. It targets a very particular set of people rather than just slowing all trading." The Association of British Insurers supported the FSA's actions even though many of its members had doubts about any benefits. The association acknowledges the political forces at play as the FSA, in a response coordinated with the Treasury and politicians, turned its rhetoric on short sellers.
Michael McKersie, the association's Assistant Director of Capital Markets, says: "We accepted at the time that circumstances in the market - and political pressure - were such that it was reasonable for the regulator to take some sort of action." He adds: "It's fair to say that investment managers are well aware that short selling bans can be counter productive. Inhibiting what is a normal market activity can have abnormal consequences and bans should be implemented only in exceptional circumstances." The Investment Management Association opposed the ban. Adrian Hood, its Regulatory Adviser, says: "The political arguments for the action by the FSA two years ago and [the action] being taken now at a European level are that it was a message to markets that they were getting carried away and that they were being regulated and they should behave more restrainedly. "We disagreed with the vilification of short sellers that was in the air at the time. It was partly the FSA but mostly the politicians who seemed to think that short selling was a bad thing and that high prices were a good thing. Accurate prices are what markets are meant to produce, and short sellers contribute to the accurate pricing of companies." In a statement for this article, Dilwyn Griffiths, a Senior Policy Adviser to the FSA, says: "We introduced a temporary short selling ban on an emergency basis at a time of great market turbulence. At the time we were concerned about the heightened risks of market abuse and disorderly markets posed by short selling in those conditions; it was not put in place to fix share prices. We believe it was the right thing to do in the circumstances." The UK ban lasted for four months but negative sentiment about short selling continues to reverberate through the world of finance. Germany banned naked short selling of eurozone government debt and major financial shares in May 2010 and the European Commission is limiting naked short selling of shares and government bonds.
Simon Gleeson, a Partner at the law firm Clifford Chance, says: "Short selling bans give the impression that government is doing something and, faced with public concern and criticism, doing something is thought to be better than doing nothing. "If this research is right, it means the decision is inevitably political, but that doesn't mean it isn't going to happen again. You have a short-selling directive going through Brussels at the moment because taking no action would be like the medicine man telling the tribe, 'Actually, I can't affect the weather after all'." The ban was imposed in market conditions more febrile than in living memory and Mr Fuld at Lehman was not the only significant player to feel the strain. The Cass academics acknowledge their research cannot capture all the elements of the story or show what would have happened if the ban had not been imposed. Professor Marsh says: "We don't know the counterfactuals [what would have happened without intervention]. We look at deals that took place and actions in the marketplace. What is clear is that there were costs that need to be weighed against unproven benefits if similar decisions are taken in future."
*Banning Short Sales and Market Quality: The UK's Experience; Ian W Marsh and Richard Payne.
Sean Farrell is a freelance business reporter.