Short-Selling Comes Under Fire Amid Bank Turmoil

A worker cleans windows at a First Republic Bank office in San Francisco on May 1, 2023. (Justin Sullivan/Getty Images)

U.S. bankers are urging federal regulators to investigate the short-selling of financial institutions as regional banks get clobbered in the stock market.

The American Bankers Association (ABA) asked the Securities and Exchange Commission (SEC), in a May 4 letter to Chair Gary Gensler, to probe the substantial short sales of bank stocks that the lobbying group says were “disconnected from the underlying financial realities.”

Rob Nichols, ABA president and CEO, confirmed that his organization’s members had seen significant short sales of equity securities since the failures of Silicon Valley Bank and Signature Bank.

While Nichols noted that the ABA accepts that short selling is a “legitimate and important financial tool,” he warned that it can be a mechanism that can “distort the markets through manipulation and abuse.”

“We urge the SEC to consider all its existing tools and to take measures to reduce the avenues for abusive trading practices and restore investor confidence,” the trade association stated, noting that “extensive social media engagement” of many banks didn’t mirror sector conditions.

“These measures include, at a minimum, a clear message, and appropriate enforcement actions against market manipulation and other abusive short-selling practices.”

Gensler issued a brief statement on May 4 acknowledging the possibility of “misconduct” in the financial markets.

Securities and Exchange Commission Chair Gary Gensler listens during a meeting at the U.S. Treasury Department in Washington, on Oct. 3, 2022. (Anna Moneymaker/Getty Images)

“As I’ve said, in times of increased volatility and uncertainty, the SEC is particularly focused on identifying and prosecuting any form of misconduct that might threaten investors, capital formation, or the markets more broadly,” he said.

Regional bank stocks have been hammered since March, especially First Horizon, PacWest Bancorp, and Western Alliance. Year to date, First Horizon shares have tumbled by 55 percent, PacWest has plunged by about 75 percent, and Western Alliance has dropped by 54 percent.

Short sellers—investors who borrow securities and plan to buy them back at a lower price to pocket the difference—have realized enormous returns in the past two months.

According to data from analytics firm Ortex, short sellers made close to $379 million in paper profits by betting against these three banks. Short sellers also made about $1.2 billion in the first two sessions of May as a result of the sharp selloff in domestic regional lenders.

A Brief History of Shorts

Short-selling serves many different purposes, such as functioning as a check on capital misallocation and fraud. Shorts can also prevent financial bubbles from forming.

Over the years, prominent individuals have held different viewpoints.

“There’s nothing evil, per se, about, in my view, about selling things short,” Berkshire Hathaway CEO and Chairman Warren Buffett said during the company’s annual shareholder meeting in 2006. “Short sellers—the situations in which there have been huge short interests very often—very often have been later revealed to be frauds or semi-frauds.”

Kyle Bass, founder and chief investment officer of Hayman Capital Management, is also opposed to short selling.

“Remember folks, when governments and management teams blame their own ineptitude on short sellers, run ... don’t walk,” he wrote on Twitter.

Tesla and Twitter CEO Elon Musk called the practice “evil,” accusing the participants of being “bad people on Wall Street to steal money from small investors.” He went as far as demanding it to be deemed illegal.

Some experts say corporate leaders who slam the strategy try to find blame when business fundamentals are weakening.

The U.S. government has banned short-selling in the past.

In September 2008, the SEC announced emergency measures to strengthen investor confidence and restore market stability by prohibiting short-selling for two weeks in about 1,000 financial stocks.

“The commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets,” then-SEC chairman Christopher Cox said in a statement.

According to researchers at the Federal Reserve Bank of New York, the plan backfired because it failed to slow the selloff in bank stocks and prices continued to decline. Shares only stabilized once the ban was lifted.

“The 2008 restrictions did little to slow the decline in the prices of financial stocks; in fact, prices fell more than 12 percent over the 14 days in which the ban was in effect,” New York Fed Bank researchers stated in a report. “In addition, the authors calculate that the bans increased trading costs in the equity and options markets by more than $1 billion. Moreover, the authors uncover no evidence that stock prices declined following the downgrade of the U.S. credit rating as a result of short selling.”

During the financial turmoil in the early days of the COVID-19 pandemic, there had been discussions about reintroducing restrictions on short-selling, following in the footsteps of South Korea.

Since 2020, Seoul has maintained a ban on short-selling, introduced to mitigate market volatility. However, in 2021, it lifted part of the ban, allowing investors to place short trades for large-cap stocks on the Kospi 200 and Kosdaq 150 indexes.

South Korean authorities are now considering removing the ban entirely this year.

“If the dust of the financial turmoil is cleared within a couple of months, we will look into deregulation of short selling, hopefully this year,” Lee Bokhyun, governor of the Financial Supervisory Service, told reporters. “We will definitely take some measures to make the market more attractive to foreign investors.”

Famed short seller Hindenburg Research recently captured business headlines when it announced that it would target well-known activist investor Carl Icahn and his Icahn Enterprises.

“Given limited financial flexibility and worsening liquidity, we expect Icahn Enterprises will eventually cut or eliminate its dividend entirely, barring a miracle turnaround in investment performance,” Hindenburg Research wrote in a note on May 2. “Overall, we think Icahn, a legend of Wall Street, has made a classic mistake of taking on too much leverage in the face of sustained losses: a combination that rarely ends well.”

Icahn Enterprises shares fell by about 25 percent last week.