Loose lips sink banks

A couple of recent developments make you realise what a fragile state market confidence is in right now, and how unscrupulous people use that to their advantage. The collapse in HBOS's share price earlier this week is a case in point. The FSA has announced that it is going to scrutinise unusual trading in HBOS shares. The clear implication here is that some in the market have been talking down the bank in order to make money by shorting it.

Sally Dewar, managing director, wholesale and institutional markets, said:

"There has been a series of completely unfounded rumours about UK financial institutions in the London market over the last few days, sometimes accompanied by short-selling. We will not tolerate market participants taking advantage of the current market conditions to commit abuse by spreading false rumours and dealing on the back of them.

"We remind market participants of the need to take extra care, in this market climate, to adhere to the market code of conduct."

So what, you might ask, that's what happens in markets. But, as the FSA quote above says, we are living in risky times. The recent Bear Stearns crisis demonstrates the problem. Only just over a week back the bank put out one statement saying that rumours of its liquidity problems were unfounded. However the market was already spooked, and investors pulled their cash, so the liquidity problem became a self-fulfilling prophecy and just a few days later Bear Stearns issued another statement confirming its acquisition by JP Morgan.

We are in a situation where greed and fear are rampant and a few whispers can start a market storm that can do serious damage. Just listen to what this fund manager has to say:

Financial markets have become a treacherous place of late and the risk of firms getting 'talked into going bust' is now very real, according to Neil Dwane, CIO for Europe at RCM.

'What is genuinely terrifying for financial markets is the power of market rumour,' he said.

Dwane points to the plight of Bear Stearns which, despite claims it had adequate liquidity and funding, found itself insolvent after a 48 hour period in which various counterparties withdrew their lines of commitment.

Dwane believes the most scary thing is the speed with which rumour can spread in the current climate with potentially fatal consequences: 'Talking to various contacts within the market, one thing becomes clear; you can get talked into going bust in these financial markets.'

This is an interesting/scary point. The HBOS incident makes you realise that there are some market participants who prioritise making money through speculation over financial stability even as we teeter on the edge - their returns are more important than causing unnecessary damage to a major bank. But then what are professional investors doing? A company's share price surely can't fall by almost 20% without some institutional investor involvement. Are they simply tailing the shorters to avoid getting stung?

Anyway, days like this are worth remembering next time someone tries to tell you that stockmarkets are about the efficient allocation of capital.