To what degree did banks’ equity price declines trigger deposit withdrawals at recently failed banks? To what degree did the withdrawals trigger declining bank equity prices? Hamid Mehran and Chester Spatt note that in either case, short-selling is not to blame and is, in fact, an essential part of a well-functioning market.
Investors who were speculating on declining bank valuations by selling shares they did not own (“short sellers”) are being blamed and scapegoated for the collapse of Silicon Valley Bank (SVB) and other regional banks. This reflects efforts to divert attention from the fundamental causes of their collapses – misjudgments by these banks and poor policy choices by the Federal Reserve and fiscal authorities over the last several years.
A variety of poor policy choices in late 2020 and 2021 on the fiscal (e.g., massive, and poorly targeted checks) and monetary side (recall “transitory” inflation) seeded tremendous inflation, which then necessitated extraordinary increases in short-term interest rates in 2022 and early 2023 for the Federal Reserve to try to achieve its 2% inflation target. Rather than being effectively hedged, some banks largely invested in longer-term instruments that resulted in substantial capital losses with rising interest rates, while funding with short-term deposits—a classic example of maturity mismatch, and in this instance, leading to a “bank run.”
While the removal of mid-size banks from the Dodd-Frank stress tests is blamed by some for the banking collapse, the stress scenario in the test was a low interest rate scenario rather than a high interest rate one. Stress testing is relevant and effective when the stress scenario targets relevant circumstances, but not irrelevant ones.
The start of the recent mini-banking crisis was not triggered by short sellers, but instead, a reaction to the maturity mismatch. Communication and sharp withdrawals among large depositors, as well as arguing that there would be a systemic crisis without an immediate extension of deposit insurance without limit despite the unprecedented extent of uninsured deposits, also played a role.
Investors soon recognized that the underlying difficulty was not unique to SVB, leading to dramatic declines in the prices of many regional banks. This points to the fundamental insight that asset values decline when buyers are not willing to pay as much for an asset as previously. While short sellers might have contributed to the sales, their role is not fundamental. In the current instances, the content of deposit withdrawals also would contribute to declining equity values. This points to the issue of causality—to what degree did equity price declines trigger deposit withdrawals vs. the withdrawals (which are fundamental) triggering declining bank values?
Like recent circumstances, in 2008, short sellers became scapegoats for bank executives and a few senior government officials, though the fundamental then was misjudgment of risk by bank senior executives and substantial declines in bank portfolio values. The recent mini-crisis mis-valuation may have arisen due to the failure to acknowledge accounting losses in the “hold to maturity portfolio.” Curiously, in 2008, at the behest of the Treasury (and White House) securities regulators banned short selling on 900 financial stocks. This sent needlessly problematic signals to the markets, undercutting price discovery by making investors suspicious about how much the regulators knew and would have led to the closure of the option markets absent exempting their market makers from the ban (though creating needless market power for the market makers).
Short selling is fundamental to the functioning of our capital markets and at the root of investor protection, as it helps protect investors against purchasing overpriced stocks and provides for more reliable and transparent price discovery. This imposes greater discipline upon senior management and regulators, can enhance risk management, and serve as a useful disciplinary tool. Weakening short selling can undercut the effectiveness of bank governance and supervision. Markets offer important and fundamental signals to help guide financial institutions and their regulators.
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