Short-Selling Attacks and Creditor Runs

LIU, Xuewen

Short selling was fingered as a direct cause of the collapses of Bear Stearns and Lehman Brothers in 2008 and the European sovereignty debt crisis in 2011. But even though these events resulted in bans on short selling, the evidence linking the two was inconclusive.

Now, Xuewen Liu has produced a model that shows these collapses may be the result of not one but two runs – yes, a run by short-selling speculators, but also another by creditors – that feed into each other to amplify uncertainties about a bank’s fundamentals. 

Banks with weaker fundamentals are more vulnerable to collapse in this scenario, and banks in general are more vulnerable than standard corporations because of the higher maturity mismatch in their balance sheets.

“In our model, the danger of short-selling attacks is that they can reduce price informativeness, leading to an increase in uncertainty and information asymmetry about the bank’s true fundamental value,” Liu said.

“First, speculators conduct short selling which increases noise in the price signal. This then lowers the expected payoff for the creditors who now face higher uncertainty about the fundamentals., and they make larger withdrawals. This in turn leads to more incentives to short among speculators.

“We believe the mechanism presented above is in line with what happened in reality. In fact, both the Securities and Exchange Commission and the European Securities and Market Authority used the key words ‘fluctuation’ and ‘volatility’ when they introduced short-selling bans. These terms to a large extent confirm that short selling increases uncertainty.”

A key point in Liu’s model is that the speculator and creditor runs, though prompted by different reasons, interact with each other. The creditors’ run in the wake of short selling encourages more short selling. “The two runs not only interact but also reinforce each other, with the result of drastically increasing the probability of the collapse of the bank,” he said.

Of course, collapse is not inevitable. Liu argues that firms with better fundamentals are less likely to be subject to short-selling attacks or to fail. But those with more maturity mismatch were at greater risk.

He warned that while short selling was an important mechanism in bank runs, there were downsides to treating it as the sole culprit and introducing bans on short selling.

“If short-selling threats exist, the bank manager has incentives to work harder to prevent them. In fact, in our model short selling increases bank failure probability disproportionately for different fundamentals.

“For a high fundamental value, the bank is little affected by short selling. But if the fundamental value is in the intermediate region, short selling drastically increases the failure probability. Consequently, with short-selling threats the bank manager has incentives to work hard to try to realise a high fundamental value and thus minimise the risk of being exposed to a high chance of failure. Without short-selling threats, banks could be induced to over-invest in illiquid assets,” Liu said.