The Regulator's Dilemma: Impact of Short-Selling Bans on Tail Risk in Equity Markets

COVID-19 forced market regulators in several European countries to introduce short-selling bans in spring 2020. This paper examines the effect of the bans on the volatility and tail risk in the equity markets. Such bans are assumed to be helpful in preventing severe market crashes: the removal of short sellers is believed to reduce falls in equity prices. I find that the imposition of restrictions increases market risk metrics such as value-at-risk and the expected shortfall of stock returns. Banks are subject to capital requirements; in relation to market risk, these requirements are based upon the risk metrics previously mentioned. A sharp change in either makes banks more vulnerable to equity price fluctuations and more likely to sell assets to cope with breached capital requirements. The additional sales caused by the latter effect lead to a further decrease in equity prices. Asset sales during crises are unlikely to be profitable, and they therefore decrease capital further. Consequently, bans on short sales that are intended to cool down market panic lead to further falls in equity prices in bank-based systems. Based on evidence from European markets in 2020, I find that short-sale bans lead to significant increases in value-at-risk (from 15 to 18%, depending on the methodology), while the expected shortfalls jump by 30%.