Select committee stuff - stock-lending

Following on from my previous post, here are some bits and pieces from the ISLA's submission to the committee's inquiry into the banking crisis. I have to say I find the ISLA's stuff really interesting reading, even if I don't agree with some of what they come out with. The text below is from this doc - pages 48 onwards.

Executive summary:

• In general, share prices are driven by changes in the underlying fundamentals of companies and not by the actions of particular groups of buyers and sellers.
• Short selling did not cause the falls in bank share prices since 2007.
• UK financial share prices have continued to fall and remained volatile following the imposition of restrictions on short selling by the Financial Services Authority in September. Independent academic research has found that the restrictions in the United Kingdom and elsewhere have had no discernible effect on subsequent movements in the prices of financial shares.
• But, based on research by the London Stock Exchange, those restrictions have reduced liquidity in the market for financial shares and raised trading costs for investors.
• They have also constrained the ability of investors to hedge their positions and led to significant compliance costs for market participants.
• ISLA welcomes the planned consultation by the Financial Services Authority on regulations for short selling. Any new regulations should be linked to clear regulatory objectives, follow full and open consultation, be evidence-based, have a sound legal basis and be subject to rigorous cost: benefit analysis, as required under the Financial Services and Markets Act 2000.
• ISLA also welcomes the initiatives by IOSCO and CESR to harmonise regulation of short selling internationally, as differing rules create confusion and compliance costs for market participants.

From a bit further in:

Short selling and share prices

4. Academic research has shown that restrictions on short selling reduce market efficiency and liquidity. Studies have found that allowing short selling:

• means prices adjust more quickly to new information about fundamentals;

• decreases the likelihood of price bubbles;

• leaves unchanged or even reduces the probability of price crashes;

• may lead to higher equilibrium prices: because investors have greater confidence that prices are fair and therefore require lower returns to compensate them for risk.

And about the Cass paper I've mentioned previously:

8. The main findings were:

• No strong evidence that restrictions on short selling changed the behaviour of stock returns. Stocks subject to the restrictions behaved very similarly both to how they behaved before their imposition and to how stocks not subject to the restrictions behaved.

• Comparing behaviour across countries where the nature of the restrictions differed, no systematic patterns consistent with the expected effect of the new regulations, i.e. no evidence of a reduced probability of large price falls.

• No sign of any detrimental impact of the constraints in terms of reduced efficiency of pricing.

• Regression analysis suggested that changes in stock returns were driven mainly by other factors affecting the financial sector as a whole rather than the restrictions on short selling. That is, some systematic changes in the behaviour of financial sector stocks could be discerned, but no strong evidence of a systematic impact of the restrictions could be identified.

Just one obvious point, two of the bits of evidence submitted appear to contradict each other. This -

Academic research has shown that restrictions on short selling reduce market efficiency and liquidity.

And this -

No sign of any detrimental impact of the constraints in terms of reduced efficiency of pricing.

I really can't get my head around this efficiency argument (which is why I'm not surprised that the Cass paper found no evidence of 'inefficiency' as a result of the ban). I'm sure there is a certain level of liquidity required in order for price formation to be broadly 'efficient' but I can't believe that long-standing equity markets like the UK's don't already have this, and that we therefore need short-selling in order to facilitate it. There's something else lurking at the back of my mind that bothers me about this efficiency argument that I can't quite articulate yet. I'll come back to it.

In the meantime if anyone has any thoughts on this one - particularly making the efficiency case - I'm all ears.