Reviewing the Late '08 Short Ban: 'By the Way, Anybody on Board Know How to Fly a Plane?'

by: Christopher Holt

Remember that scene in the movie Airplane! when flight attendant Elaine Dickinson announces over the intercom,

“There’s no reason to become alarmed, and we hope you’ll enjoy the rest of your flight. By the way, is there anyone on board who knows how to fly a plane?”

Naturally, passengers on the ill-fated Flight 209 listened attentively to the announcement, then proceeded to totally panic.

Well, according to a recent study on the 2008 short sale bans, that’s basically what regulators did in response to the financial crisis. They tried to calm everyone down. But instead, the paper says that they inadvertently caused “markets to overreact” by removing a central player in the market equilibrium – the short-seller. This, according to a new study on the topic.

The study by Edhec’s Abraham Lioui explores the market behaviour directly attributable to the short bans by removing the background noise of the financial crisis (easier said than done of course).

Last May, we told you about a similar research study by Lioui that explored the effects of the ban on short selling during the financial crisis in 2007 and 2008 (“The Undesirable Effect of Banning Short Sales”).

Lioui’s new paper is a “substantial revision” to that study and is called “Spillover Effects of Counter-cyclical Market Regulation: Evidence from the 2008 Ban on Short Sales.” While the conclusion is essentially the same – that the short bans perverted regular market behaviour – this update pays particular attention to the market-wide effects of the bans. It compares these market-wide effects to the bans’ impact on financial indices per se (recall that the bans applied to financial names only). According to Lioui, “It seems there are no studies that address the effects of limits on short sales that may spill over to all segments of the market.”

In addition, the updated version examines market behaviour during the exact dates of the short ban in each respective country studied (US, France, Germany, and the UK). Further, it attempts to strip out the effect of the crisis-induced drop in liquidity from the direct effect of the short bans in order to determine if the decision to ban short selling exacerbated an already bad situation.

The disentanglement process involves the creation of dummy variables that apply only to the daily returns in the short ban periods. Not only did these dummy variables have significant predictive power, but according to Lioui, “The only variables that had a systematic and sizable impact on the daily volatility are the short dummies.”

In fact, the short dummy variables maintained their predictive power even when exploding credit spreads and diminishing trading volumes were accounted for.

While it might be tempting to conclude that short bans increased the negative skew of broad indices, Lioui cautions against this, pointing out that the bans seem to have had a positive impact on the skew of US market returns but a negative impact on the skew of European ones. Furthermore, the bans seem to have had a different effect on skew during each of the two unique sub-episodes of the short ban saga (July/Aug ‘08 and Sep/Oct ‘08).

The specific effect of the short bans on kurtosis is also somewhat muddy. As Lioui concludes, “…extreme movements were more frequent during the ban than in the pre-crisis period”. But was this the result of the bans themselves or a result of the background noise of the financial crisis?

It turns out that the bans themselves likely contributed to kurtosis (of financial indices), but that the effect is weak. Lioui concludes that “For other reasons, the market, broadly speaking, also experienced a surge in tail events.”

Despite the somewhat inconclusive relationship between the bans and higher statistical moments, the paper is clear in stating that the impact of the bans themselves was greater than than the impact of the background financial crisis at the time.

The basic conclusion of this paper is that the transmission mechanism between stock-specific short bans and market wide drops is old fashioned fear. When you scare the hell out of investors by forcibly removing any important players from the market, they will react negatively. Writes Lioui:

“The reaction of the broad indices may also reflect a growing lack of confidence of the uninformed or less sophisticated investors following the measures taken by the market authorities. The markets clearly view the real world as a world of asymmetric information and, as such, the market authorities must be aware that regulatory actions do not have a unique equilibrium implication.”

“For the aggregate market, one possible interpretation could be that this excess volatility is the outcome of the fluctuating sentiment of the markets: investors in the markets change their beliefs about future economic prospects too often and thus (over)react to any signal they receive.”

So it appears the lesson to regulators is: Next time, try to avoid announcing to the passengers that you don’t know how to pilot the financial system through a storm.