Securities regulators around the world have temporarily banned the short-selling of financial services stocks, a measure that has seemingly done little to prevent harm to those stocks while causing some collateral damage.

On Sept. 18, the U.S. Securities and Exchange Commission and the Britain’s Financial Services Authority announced bans on the short-selling of certain financial services stocks. To prevent regulatory arbitrage, various members of the Canadian Securities Administrators joined the cause on Sept. 19, banning short-selling of interlisted financials in support of the SEC’s measure. Regulators in other jurisdictions soon implemented bans of their own.

The SEC and CSA bans were meant to expire on Oct. 3. (The FSA’s prohibition extends until mid-January 2009.) But the SEC extended its moratorium to give the U.S. Congress time to adopt legislation designed to salvage the financial system. The ban is now due to expire three days after such legislation is adopted, but no later than Oct. 17. Congress finally passed that legislation on Oct. 3, and the U.S. president has signed it.

As a result, the CSA has agreed to extend its ban to midnight on Oct. 8, keeping its prohibition in line with the SEC’s.

The rationale for these prohibitions on short-selling is to shore up market confidence. When the SEC first adopted its ban, it said it was trying “to protect the integrity and quality of the securities market and strengthen investor confidence.”

In particular, the SEC worried that aggressive short-selling of financial services stocks would undermine faith in the firms themselves. This is particularly pernicious in the financial services sector, the SEC argued, because financial services institutions are vulnerable to crises of confidence, which can scare off trading counterparties, thereby threatening their ability to do business.

The move came after faith in the financial services sector was shaken by a string of unprecedented moves: Lehman Brothers Holdings Inc. was allowed to fail; Merrill Lynch & Co. Inc. hurriedly sold itself to Bank of America Corp.; insurance giant American International Group Inc. sold a large stake in itself to the U.S. government; and, in Britain, HBOS PLC sold itself to Lloyds TSB Group PLC. Understandably, regulators were concerned about further damage to the sector.

But since the ban was adopted, the problem has scarcely abated. The two remaining large, independent investment banks — Morgan Stanley Inc. and Goldman Sachs Group Inc. — have had to convert to bank holding companies and submit to more intense regulation. Morgan Stanley also found a Japanese financial institution, Mitsubishi UFJ Financial Group, to take a 20% stake to shore up the former’s capital position.

The Federal Deposit Insurance Corp. had to broker the sale of the banking operations of two other major U.S. firms, Wachovia Corp. and Washington Mutual Inc., to Citi-group Inc. and J.P. Morgan Chase & Co. Inc., respectively, after the former two firms ran aground. Wachovia then struck its own deal with Wells Fargo & Co. (although, as Investment Executive went to press, it was unclear whether regulators would support that last transaction).

As well, the pain has spread to a number of European financial services institutions, necessitating a handful of major rescues and government interventions to prevent collapses.

Evidence suggests the ban on short-selling was not able to prevent the fate of any of these firms. Nor has confidence returned to investors or bank counterparties. Instead, the U.S. Treasury’s proposed rescue bill has been pushed as necessary to prevent financial Armageddon.

In fact, conditions have only worsened since the ban on short-selling was adopted. That’s not to say that the ban caused market confidence to deteriorate further in recent weeks. Arguably, things would have been just as bad, or even worse, without the ban. But there’s certainly no evidence that the ban has worked to restore confidence.

What is certain is that the ban on short-selling is having negative effects in certain quarters. For example, companies that aren’t covered by the ban have had to absorb the surplus of short-sellers that have been forced to look elsewhere to place their bets.

Speaking at a conference hosted by CIBC World Markets Inc. in late September, Bill Holland, CEO of Toronto-based CI Financial Income Fund, complained that companies such as his, which are reasonable proxies for the banks, found their share prices under pressure once regulators decided to implement a ban on short-selling certain financial services stocks but not others.

@page_break@Indeed, the companies on the ban’s list saw their stock prices decline by just 1.1% during the first week of the ban, Sept. 19 to 26. Meanwhile, a collection of 17 Canadian financial services firms not covered by the prohibition — including banks, asset managers and brokers — saw their share prices fall by an average of 6.5% for the week. Five of those firms’ shares suffered double-digit drops, and only one saw its share price rise during that period.

The average decline in the unprotected financials was more or less in line with the overall index, as the S&P/TSX composite index was down by 6.1% during that period.

In Australia, fear of increased short-selling in sectors other than financial services caused regulators to ban short-selling, both naked and covered, in all sectors for 30 days after Sept. 22.

The Australian Securities and Investments Commission gave the same basic explanation for its ban on short-selling as the SEC and FSA — to ensure market fairness and maintain investor confidence amid extreme conditions. The ASIC also decided, however, that because its market is relatively small, all stocks should be protected. “To limit the prohibition to financial services stocks, as has been done in Britain, could subject our other stocks to unwarranted attack,” explained ASIC chairman Tony D’Aloisio at the time of the ban, “given the unknown amount of global money which may be looking for short-sell plays.”

After 30 days, the ASIC will consider lifting the ban on covered shorting in non-financial services stocks. Its ban on financial services sector shorting is to be reviewed in line with actions taken by the U.S. and Britain.

In Canada, it does not appear that financial services firms not covered by the ban have faced any huge short position buildups following the imposition of the ban. The biweekly Toronto Stock Exchange short report, which shows the top 20 short positions for the two weeks ended Sept. 30, does not include any unprotected financial services stocks. Moreover, the total volume of top 20 shares sold short declined from the prior period, to 401.1 million shares as of Sept. 30 from 416.4 million in the previous two-week period.

Nevertheless, the wisdom of these bans has been questionable from the outset. For one, the optics are terrible. It portrays the regulators as market bulls, taking the position that share prices should only be allowed to go up. Moreover, the ban makes it look as if the regulators are favouring financial services firms, some of which lobbied for the ban, over other sectors.

While regulators insist that they see the value in short-selling — it increases market liquidity, contributes to efficient price discovery, allows hedging and risk management and helps derail bullish market manipulations — the ban undermines that position.

American analysts have observed other problems caused by the ban in that market. Speaking on a conference call hosted by RiskMetrics Group, Barry Ritholtz, CEO and director of equity research with New York-based Fusion IQ, reported that the ban on short-selling is proving to be counterproductive in certain situations, such as when the whole market is selling off.

In these market conditions, the stocks that can’t be shorted are declining more precipitously than the overall market, Ritholtz reports. Ordinarily, when stocks are trading down heavily, that’s when the short-sellers come in to cover their positions. “They’re the natural floor in a crash,” he says. “So, when you take them out of the market, you’ve basically said, ‘No parachute’, and pushed them out the door.”

Another constituency that’s not pleased with the ban are the inves-tors who are being prevented from carrying out their trading strategies. Indeed, a survey conducted by research firm Greenwich Associates in late September found only limited support for the ban. The survey asked slightly more than 900 institutional investors (asset managers and pension funds) and large companies for their reaction to the ban on short-selling. The survey found that just 25% of respondents agreed with the ban, 60% said that short-selling of financial services stocks should be allowed and 15% were undecided.

Opposition to the ban was strongest among asset managers, Greenwich reported. Pension funds also opposed the ban but by a narrow margin; large companies, however, supported it. (Only 32% said that the shorting of financial services stocks should be allowed.)

One reason for investor displeasure is the fact that taking the shorts out of the market has reduced liquidity. Zach Gast, head of financial sector research with RiskMetrics, reported during the conference call that the ban has increased the cost of trading in the protected securities because of the loss of liquidity in those names, and over time it is probably going to affect the performance of the funds that trade those stocks.

The Greenwich survey also suggests that hedge funds are being unfairly punished by the ban. It reports that the ban on short-selling is having a significant impact on the hedge fund industry, as managers are forced to rejig their sometimes complicated trading strategies to comply with the new rules.

Moreover, in reducing the pressure on financial services shares in equities markets, regulators might have inadvertently created pressure elsewhere. Nouriel Roubini, chairman of RGE Monitor, suggested during the RiskMetrics call that because the short-sellers can no longer take certain positions in the stock market, they are being pushed into the credit-default swap market to make their bets, widening spreads in that arena and putting still more pressure on financial services firms.

It is characteristic of this crisis that regulators have scrambled to come up with ad hoc solutions to systemic problems without much success. The ban on short-selling was surely well intentioned, but it has seemingly had many negative, unintended consequences. IE