Yesterday Once More: Short Selling and Two Banking Crises

Many studies on bank performance have tried to understand underperformance during financial crises, particularly compared to their banking peers. For example, Fahlenbrach, Prilmeier, and Stulz (2012) show that the persistent culture in a financial institution regarding risk-taking behavior plays an important role. They find that a bank’s performance in past crises could be a proxy for its systematic risk exposure or its sensitivity to the next crisis. Consequently, the performance of a bank in a past crisis predicts its performance in the next crisis. In our paper, we investigate whether short sellers are informed about the persistent risk culture in banks and whether they target the banks with high-risk exposure before the next financial crisis.

We focus on short sellers because they serve as important information intermediaries in multiple dimensions. The literature shows that short sellers are informed about future stock returns and firm performance. For example, Ho, Lin, and Lin (2016) find that short selling reduces the information asymmetry and agency costs between firms and banks and results in lower loan spreads for firms in the Reg SHO PILOT program of the US Securities and Exchange Commission. We thus conjecture that short sellers might also be informed about the poor performance of some banks before the occurrence of a financial crisis and capitalize on that private information. If that is the case, then we expect that short interest (ie the quantity of shares that investors have sold short but not yet covered or closed out) should increase during pre-crisis periods and be positively correlated with the crisis returns of the banks. We thus hypothesize that short sellers are informed about the poor performance of some banks in the 1998 long-term capital management crisis (LTCM crisis) and the 2007–2009 financial crisis (financial crisis).

Meanwhile, there are an increasing number of studies that explore the influence of corporate culture in various aspects of firms and banks. In particular, in a speech delivered on 20 October 14 2014, William C. Dudley, the president and CEO of the New York Fed, pointed out that: “I will focus on how incentives could be improved within the financial services industry to encourage better culture and behavior.” Dudley cautioned against an overly risky business model for banks that makes them more vulnerable during crises. The weakness of the banks is an opportunity for short sellers to make sizable profits if they can identify the banks with an overly risky business model. Therefore, combining the argument on the persistence of the banks’ risk culture and our first hypothesis, we also hypothesize that short sellers tend to target the banks that had high-risk exposures in a previous crisis when they anticipate an imminent financial crisis. Following Fahlenbrach, Prilmeier, and Stulz (2012), we use banks’ stock returns during the 1998 LTCM crisis to represent the potential risk exposure in the 2007–2009 financial crisis. If short sellers indeed target banks with overly risky business models, then we should find that the bank’s returns during the LTCM crisis are negatively correlated with the short interest on these banks before the 2007-–2009 financial crisis.

Our results provide supportive evidence that there is a negative correlation between the change in short interest before the crisis and the stock performance of banks during the two crises. We also find that before the financial crisis, the short selling concentrates on the banks that performed relatively poorly in the LTCM crisis. This evidence is in line with Fahlenbrach, Prilmeier, and Stulz, (2012) who argue that there is a persistent risk culture among banks and that this very culture of taking overly high risks makes these banks the targets of short sellers before a crisis.

Further, we provide additional evidence to support our main findings. First, banks that are shorted more before the crisis have lower loan quality and higher default risk in the financial crisis. Second, the crisis return predictability of short interest is stronger among the riskier banks. Third, our quantile regression analysis indicates that the crisis return predictability of short interest is stronger for the lowest quantile levels. Collectively, these results provide evidence that short selling predicts the performance of banks in the crisis period and that short sellers can identify the banks with a persistent culture of high-risk behavior.

Chih-Yung Lin is Associate Professor at the College of Management at Yuan Ze University.

This post is based on a paper Associate Professor Lin co-authored with Associate Professor Tse-Chun Lin from the University of Hong Kong and Dien Giau Bui from the National Taiwan University.