Predatory Short Selling

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.

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

“…() . 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 () and Liu ().…”

“…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 () and Liu (). 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.…”

Short‐Selling Bans Around the World: Evidence from the 2007–09 Crisis

“…In terms of Miller's (1977) model, stock market regulators may have regarded the bans as necessary to prevent “underpricing” of stocks: they probably feared that, with optimistic investors largely neutralized by funding constraints, unbridled short sales would trigger an unwarranted collapse in share prices 20 . Indeed, Brunnermeier and Oehmke (2008) argue that such intervention may be temporarily justified for the stocks of financial institutions, when these become vulnerable to predatory short selling, as aggressive short selling may cause such institutions to violate their regulatory capital constraints and force them to liquidate long‐term investments at fire‐sale prices. In this section, we examine whether the bans provided effective support for the prices of financial stocks when benchmarked against exempt stocks.…”

Information Transmission across European Equity Markets During Crisis Periods

“…A similar mentality was adopted by European regulators when dealing with the European sovereign debt crisis between 2011 and 2012. Brunnermeier and Oehmke () argue that a ban can prevent a stock price decline that may force a bank to sell‐off assets (typically at fire sale prices), to prevent them from hitting a leverage ratio constraint. However, Beber et al () find that such short‐selling bans, on the contrary, increase the default probability of vulnerable financial institutions and can further destabilise the market.…”