33 - Regulation, Regulatory Uncertainty and the Stock Market: The Case of Short Sale Bans

Abstract

During financial crises, regulators become key players in the market. In the summer of 2008, regulators across several countries imposed restrictions and bans on short selling with the duration and specificities of these constraints varying across jurisdictions and offering opportunities for research into their effects. In this chapter, we review classical models about constraining short sales, the empirical evidence prior to the 2007–2009 financial crisis and the empirical evidence to date of the effect of the regulatory action in banning short sales on liquidity, price discovery and return distribution of broad indices, and on prices. The evidence suggests that something is missing in traditional models, and that constraining short sales significantly reduces market quality and can have unintended consequences. Regulators, however, continue to resort to short sale bans in moments of market stress, as most recently seen in several European countries in August 2011. Initial work on new models that incorporate uncertainty about government policy into stock prices appears promising and poses challenges to researchers to broaden models in order to incorporate regulatory risk.