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Why did this seem like a good idea?

In recent days, Greece, followed by Belgium, France, Italy and Spain, have banned short-selling of the shares of banks and other financial companies, receiving in response almost universal condemnation by analysts, fund managers, academics and media commentators.

So why on earth did they do it?

The symptom they have responded to is recent extreme volatility in bank stocks, around a sharp downward trend.

The underlying cause however has been investor concern about the credit worthiness of much eurozone government debt, which is held within the banking sector, and has previously been highly rated within the banks’ capital requirements. Recent action by the ECB to support the Spanish and Italian government bond markets led to brief rallies in these markets, but has not calmed investor fears that sooner or later the banks holding these bonds will need to write down their value, as has already happened with Greek debt.

Hence the investor rush for the exit.

For the authorities to try to stem this rush by banning short selling seems to display a horribly worrying understanding of market – and particularly hedge fund – mentality.

One of the many quotes from fund managers in the FT of 12 August illustrates this well – ‘The EU policymakers don’t seem to understand the law of unintended consequences. The vast majority of short selling (and purchases of credit default swaps) in financial shares is by other financial institutions hedging their counterparty risks, not speculators. The interbank lending market froze up completely in October-December 2008, after the September 2008 short selling bans.’

Another huge flaw is that the measures came after efforts by the European Securities and Markets Authority to co-ordinate an EU-wide response failed, meaning that the ban applies only within five countries – allowing short selling of the impacted stocks to continue in any of the other financial centres they are traded in outside Belgium, France, Germany, Italy and Spain.

Besides which, it is not clear how much of the decline in share prices in recent days was being driven by short selling anyway.

History in the crisis of 2008 appears to have demonstrated decisively that banning short selling didn’t work in supporting the impacted stocks. The only way to reassure investors they ought to keep their money in a company is to demonstrate its underlying profitability and growth potential. For many of the European banks at present, the misguided, protectionist actions of the monetary authorities and politicians are making that an increasingly difficult task for the companies they say they are trying to support.

As in the United States, what is needed in the eurozone is decisive action to allocate spending towards projects that will promote long term growth and an increase in the savings ratio, whilst cutting political corruption and tax avoidance by global corporations. Unfortunately for all of us involved in banking and finance, that action remains completely lacking.