The US government said it will keep an eye on "short-selling pressures on healthy banks", with federal officials looking into whether the recent volatility in banking shares was caused by "market manipulation".
With two more regional banks – PacWest and Western Alliance – listing badly yesterday, there were also renewed calls for a ban on short selling to protect companies from attacks by hedge funds.
Yesterday PacWest shares fell over 50% as the American markets opened after it became the latest lender to eye up a rescue deal, with Western Alliance down 39%, while Metropolitan Bank was down 10.5%.
At the start of the week the collapse of First Republic Bank (NYSE:FRC) was averted by a takeover by JPMorgan, making it the third US mid-sized lender to fail in two months.
Short sellers made an estimated US$378.9mln in paper profits on Thursday alone, analytics firm Ortex reported.
US law firm Wachtell, Lipton, Rosen & Katz, which worked with Twitter on its takeover by Elon Musk, said the Securities Exchange Commission (SEC) to restrict "coordinated short attacks" by financial institutions.
In the letter to its clients, the law firm said the SEC should regulate by imposing a 15-trading day prohibition on short sales, which would give regulators time to act and for investors to digest information.
They said attacks by short sellers are often not related to fundamental performance and put the US economy at "great risk."
Market analyst Neil Wilson at Markets.com said: "If you are a regulator and want to signal you think the market is at fault for doing the job that you, the regulator, ought to have done, then it kind of makes sense (I guess?) to get in front the market by saying ‘you can’t do that anymore’, we will deal with it now."
The SEC and UK regulators did ban short sales on domestic financial stocks in 2008, stating that “unbridled short selling is contributing to the recent sudden price declines in the securities of financial institutions unrelated to true price valuation.”
Wilson noted that research on these bans showed they actually tended to reduce market liquidity and slow down price discovery, while failing to prevent declines based on economic fundamentals.
A 2014 Cass Business School study paper looking at short selling bans in 2008-09 and 2010-11 suggests a ban leads to more volatility, greater declines in stock prices and a higher likelihood of default.
"The thinking is that the regulators ban short-selling to buy time to come up with some kind of plan to rebuild the industry. There may need to be a ‘whatever it takes’ line in the sand moment – clearly the US authorities haven’t done that – it may be that a ban on shorting bank shares forms part of that. Remember this bank stress is just on being the wrong side of rates, we’ve not even had a recession or full credit cycle," said Wilson.