Disentangling the effects of the short bans from those of the broader financial crisis

Hedge Fund Regulation 03 May 2009

Several recent studies have indicated that the ban on short selling some stocks implemented last fall had a negligible, if not a negative, impact on markets.  Not only did the bans fail to halt the downward slide in stock markets, but they also led to an increase in bid-ask spreads – a sure sign that market liquidity (and thus efficiency) declined.

But one of the ongoing challenges these studies have faced was to determine how much of the post-ban slide in markets was the result of the continuing (and even accelerating) market mayhem and how much might have actually been caused by the bans themselves.  In fact, a new analysis by Abraham Lioui of French research centre Edhec-Risk says that these studies “are unable to disentangle the impact of the ongoing crisis in the financial markets from the impact of the ban on short selling.”

Lioui proposes another approach to “disentangling” the effects of the financial crisis and the effects of the short-bans themselves.  They come to the “odd” conclusion (their description) that equity indices seem to have responded more “strongly and systematically” to the short bans than did the so-called “off-limits” stocks themselves (those where shorting was actually banned).

We summarize Lioui’s conclusion below:

Now, you might be thinking that the macroeconomic environment during the short ban period (defined here as Sep 2008 to Jan 2009) was so different from the preceding “financial crisis period” (Jul 2007 to Aug 2008) that you simply can’t compare apples to apples.  Perhaps the deterioration in macroeconomic environment just pushed indices down further while the “off-limits” stocks benefited from the short bans.

Lioui’s paper addresses this possibility by adding several key macro-economic variables to the regression to see if the conclusions remained the same.  It turns out that when you account for things like the TED spread and credit spreads, the conclusion was in fact the same:

“…the market reacted more strongly to the ban than did the stocks that were the object of the ban.”

While it would appear that such a conclusion could be an endorsement of the bans, Lioui points to increasing market volatility during then ban as evidence that the ban itself may have basically freaked-out the markets – causing more volatility in the meantime:

“This reaction is perhaps indicative of the market’s lack of confidence in the capacity of the regulatory authorities to guarantee fair markets and thus protect investors from those with the capacity to manipulate.”

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