Should Short-Selling Be Restricted During a Financial Crisis?

Abstract

This paper investigates the short selling of financial company stocks around the time of the SEC September 2008 short-selling ban. More specifically, this paper examines whether this short selling, mainly by hedge funds and other types of sophisticated investors, was purely speculative or whether it was driven by rational behavior in response to a financial company's risk exposure, such as its holdings of subprime-related assets and its credit risk exposure. Our results show that during the crisis period the short-selling of financial firms stock was not significantly greater than that of non-financial firms, even after controlling for size and risk. More importantly, our results show that short sellers rationally short sold those financial company stocks with the greatest subprime and insolvency risk exposures. This finding has important implications regarding banning short selling, since it suggests that such a regulation may mute the disciplining effects of investors in the financial market on those financial companies with the greatest risk exposures and would be contrary to the intentions of bank regulators who have emphasized an increased reliance on market discipline.