A temporary ban on short selling financial stocks in several European countries is helping to calm global markets after a week of unprecedented share price swings. But a fight by regulators to stamp out what they consider reckless trading in the shares of some of Europe's largest banks is only getting started.
European banks, among the most volatile stocks in recent weeks, gained 4.2 per cent Friday after Belgium, France, Italy and Spain enforced a temporary freeze on short selling, suspecting that fear-mongering was undermining markets and could ultimately threaten the ability of several European banks to raise money.
The calming effect spread across the Atlantic. After a rocky week of trading, Canadian banks were relatively flat, having gained back most of their losses from earlier in the week. U.S. banks fell 2 per cent on Friday, a small drop compared to the roller coaster ride financial stocks were on earlier in the week. The markets as a whole were much more stable, with the S&P/TSX index and the S&P 500 index in the U.S. up slightly.
However, European lawmakers are stepping up efforts to combat what they see as disruptive trading. Spain's Economy Minister Elena Salgado suggested more countries will soon join the ban on short-selling – where investors profit when share prices plummet – while officials in France said they were launching a formal investigation into unusual trading in French bank stocks.
Short selling can become a problem if it feeds market uncertainty. Just as a rising stock prices can gain momentum as more investors buy in, the emergence of large short positions can sometimes spur panic that leads to a massive selloff. France's second-largest bank, Société Générale SA, lost a third of its value in the past month and fell 15 per cent on Wednesday amid rampant speculation that the bank could face short-term funding problems.
Executives with the bank moved quickly to denounce "all rumours." However, when stability was not restored to European financial stocks, regulators in France said they would seek to punish anyone spreading false information. "We are investigating the unfounded rumours that hit specific stocks this week," Jean-Pierre Jouyet, the president of France's stock market regulator, told reporters in Paris.
France, whose banks came under a specific attack, is imposing a 15-day ban on short selling financial stocks, as is Spain, while Belgium is halting it indefinitely. Italy did not put a timeline on its ban. Greece introduced a similar ban on Monday, which will last two months. Those countries tried to convince other countries in the euro zone to take part in a Europe-wide freeze, but couldn't get a consensus.
The move is similar to a freeze put in place during the credit crisis by regulators in the U.S., Canada and Europe to halt a slide in bank shares. However, the U.S. Securities and Exchange Commission indicated on Friday it does not intend to revisit the freeze, and Canada has given no signs of moving either.
Academics are divided on the effectiveness of halting short selling amid market volatility. While some have argued it can stop negative sentiment from dragging down a stock on unfounded rumours, arguments are being raised this week that the halt a few years ago during the credit crisis had no direct impact on stabilizing markets. Still, European regulators said the steps were being taken because of unusual swings in financial stocks, particularly in France.
"European financial markets have been very volatile over recent weeks," the European Securities and Markets Authority said in a statement announcing the ban. "Recent developments have meant that all competent authorities have reinforced the monitoring of their markets and are keeping their regulatory requirements under review."
With French banks holding a considerable amount of Europe's sovereign debt, there is concern that a worsening of the financial crisis would drag down the sector as the contagion spread. "There is risk in the banks that are holding these bonds and that's why we've seen this concern about France … because the French banks are large owners of these individual country bonds," said Sherry Cooper, chief economist at Bank of Montreal.
Paul Taylor, chief executive officer of BMO Harris Private Banking, said there is little risk of those problems infecting Canadian banks, which has sheltered them from some of the worst stock price swings this week.
"The Canadian banks have very limited exposure to the European sovereign debt issues, so I would say that's a very insignificant issue," Mr. Taylor said, adding that a slowdown in the North American economy will have a more direct impact on Canadian bank stocks. BMO lowered its growth forecast for the U.S. economy by about a third on Friday. The bank expects U.S. growth will now be about 1.7 per cent this year. Canada's economy is expected to expand by 2.4 per cent this year, and a slightly slower 2.3 per cent next year.
"The Canadian banks obviously will be much more prone to the broad economic cycle. If the economy is not growing at the pace we might have expected, then the loan book will not be growing," Mr. Taylor said.