Predatory Short Selling*

Abstract

Abstract. Financial institutions may be vulnerable to predatory short selling. When the stock of a financial institution is shorted aggressively, leverage constraints imposed by short-term creditors can force the institution to liquidate long-term investments at fire sale prices. For financial institutions that are sufficiently close to their leverage constraints, predatory short selling equilibria co-exist with no-liquidation equilibria (the vulnerability region) or may even be the unique equilibrium outcome (the doomed region). Increased coordination among short sellers expands the doomed region, where liquidation is the unique equilibrium. Our model provides a potential justification for temporary restrictions on short selling of vulnerable institutions and can be used to assess recent empirical evidence on short-sale bans.

Predatory Short Sales and Bailouts

“…Second, in our model bailouts are a better policy tool than short selling restrictions. This augments theoretical results on the optimality of short sale restrictions obtained by Brunnermeier and Oehmke (2014), Goldstein and Guembel (2008) and Liu (2015). Finally, welfare gains are unevenly distributed: shareholders gain while taxpayers lose, which contributes to the debate over the redistribution effects of bailouts (e.g., Acharya et al, 2011).…”

“…As in Brunnermeier and Oehmke (2014), Goldstein and Guembel (2008) and Liu (2015), aggressive shorting can be profitable because it triggers inefficient actions by the shorted company. These studies, which do not consider bailouts, find that short selling restrictions can be welfare increasing.…”

The Impact of the 2011 Short‐Sale Ban on Financial Stability: Evidence from the Spanish Stock Market

“…In principle, a positive relationship between short sales and default risk could be indicative of the fact that short sellers are informed traders who may anticipate rating downgrades by exploiting market-based default-risk indicators, as argued by Henry et al (2015). 7 Alternatively, a positive link between both variables could reflect some form of causality from short sales to default risk, in line with the arguments of Brunnermeier and Oehmke (2014) and Liu (2015).…”

“…We now analyse whether the effect of the ban on banks could be consistent with a short-sales channel of default risk along which aggressively shorting a bank stock could per se lead to a low-valuation equilibrium, along the lines of the theoretical arguments of Brunnermeier and Oehmke (2014) and Liu (2015). Against such a possibility, the ban could have contributed to removing a self-fulfilled low-valuation equilibrium that could potentially lead to the liquidation of some viable firms.…”

“…The potential linkage between the short selling of financial stocks and banking stability has recently been explored from a theoretical standpoint in several articles. Brunnermeier and Oehmke (2014) explore a setting where short-term creditors impose leverage constraints on financial institutions. Then, when a firm is sufficiently close to such constraints, by aggressively short-selling its stock, short sellers can force its liquidation.…”