Short-Sale Constraints and Credit Runs

Abstract

This paper studies how short-sale constraints affect the informational efficiency of market prices and the link between prices and economic activity. I show that under short-sale constraints security prices contain less information. However, short-sale constraints increase the informativeness of prices to some agents who learn about the quality of an investment opportunity from market prices and have additional private information.Then I apply this observation when modeling a run on an investment bank by its short-term creditors, who are endowed with dispersed information and also learn from the price of an asset the bank holds. I show that short-selling constraints in the financial market lead to the revival of self-fulfilling beliefs about the beliefs and actions of others, and create multiple equilibria. In the equilibrium where agents rely more on public information (i.e., the price), creditors with high private signals are more lenient to roll over debt, and a bank with lower asset quality remains solvent. This leads to higher allocative efficiency in the real economy. My result thus implies that the decrease in average informativeness due to short-sale constraints can be more than compensated by an increase in informativeness to some agents.