Otherwise shorting is a benefit for the market, and there's no better indication of that than to examine what happens when stocks stop being shorted. It's not pretty. The subject has been examined up, down and sideways by academic researchers, and the results are always the same: short-selling bans are a bad idea.
Unfortunately, in 2008 global market regulators gave academic researchers plenty of opportunity to study short-selling bans, and to determine what a rotten idea they truly are.
One particularly useful study of the panic among regulators during the financial was authored by European academics Alessandro Beber and Marco Pagano (you can
find it on the Social Science Research Network
Web site). They began their study by quoting two assertions by Chris Cox, head of the Securities and Exchange Commission in 2008, concerning a ban on shorting of financial stocks at the height of the financial crisis.
Cox said in September 2008 that the purpose of his emergency order was to "restore equilibrium to the markets." Only four months later, in an interview with
, Cox had changed his mind. "Knowing what we know now, I believe on balance the commission would not do it again," Cox said. "The costs (of the short-selling ban on financials) appear to outweigh the benefits."
Beber and Pagano point out that regulators should have known better. They note that "theoretical reasons and previous evidence cast doubt on the benefits of short-selling bans, suggesting instead that they may reduce market liquidity and hinder price discovery, while not necessarily supporting security prices."
Indeed, the shorting ban couldn't have come at a worse time. "If short-selling bans did contribute to the decrease in stock market liquidity in 2008-09, they would have inflicted serious damage on market participants who sorely needed liquidity and could hardly obtain it on fixed income markets," their study points out.
Beber and Pagano sifted through daily data for 16,491 stocks in 30 countries, from January 2008 to June 2009. They found that "the short-selling bans imposed during the crisis are associated with a statistically and economically significant liquidity disruption," as measured by widened bid-ask spreads -- the curse of investors everywhere. The effect, they found, was particularly severe with small cap stocks.