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France's President Nicolas Sarkozy and Germany's Chancellor Angela Merkel (R) pose for a family photo during a two-day EU leaders summit in Brussels March 19, 2009.

Francois Lenoir/REUTERS

European leaders are scrambling to halt a crisis of confidence in the financial system that has spawned some of the most volatile markets since the crash of 2008.

In a controversial move aimed at stabilizing the wild swings in European equity markets, Belgium, France, Italy and Spain banned short selling in some financial stocks, mirroring a move taken by regulators in the U.S., Canada and Europe during the depths of the credit crisis to halt a slide in bank shares.

The European Securities and Markets Authority issued a statement saying the ban could be expanded to more countries amid concerns that false information is being spread about European banks by short-sellers looking to profit from the current climate of fear. Short-sellers are investors who bet stocks will go down.

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Just as a sudden rise in shares can feed a buying spree in certain companies, large short positions can also stoke worries about the underlying financial health of financial institutions, causing investors to rush for the exits.

"While short-selling can be a valid trading strategy, when used in combination with spreading false market rumours this is clearly abusive," the European regulator said.

The ban on short selling came as a series of high-level talks are unfolding across Europe. French President Nicolas Sarkozy and German Chancellor Angela Merkel agreed to hold an emergency meeting Tuesday to discuss steps to stabilize their markets.

And in Britain Thursday, Chancellor George Osborne used a special session of Parliament to reassure the country that U.K. banks are holding sufficient capital to withstand a debt crisis in Europe.

At least for a day, those efforts appeared to calm investors' nerves.

After suffering deep losses earlier this week, European financial stocks staged a rebound and helped inspire a broader market rally in North America, which was also fuelled in part by lower-than-expected jobless numbers out of Washington. In Canada, the S&P/TSX composite index rose 2.79 per cent, the second largest one-day gain in more than two years.

Several large financial institutions, including France's Société Générale SA, finished the trading day up, capping one of the best days in the European markets in nearly a month. The French bank has been one of the hardest hit by growing concerns that the sovereign debt crisis in Spain, Italy, Greece and elsewhere could spread throughout Europe.

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Halting short selling does not necessarily bode well for the health of the markets, since it's an unusual move that constricts normal trading. The decision came after a hastily-arranged conference call held by European financial regulators Thursday to discuss the impact on banks, and whether short selling was feeding the market instability.

Reports suggested an outright ban across Europe was discussed, though only a handful of countries decided on taking such steps. France and Spain are imposing a 15-day ban on short selling financial stocks, while Belgium is halting it indefinitely. Italy did not put a time line on its ban.

"While [banning short selling]may have been good as an excuse for a rally, extraordinary measures are still a sign of weakness," said Colin Cieszynski, market analyst at CMC Markets Canada. "Strong markets don't need them."

Greece has already banned short-selling of its embattled banks stocks for two months. Even though academics are divided on whether halting short selling can actually prevent an unnatural slide in the markets, Turkey and South Korea also have bans in place.

European regulators are also stepping up surveillance of their financial markets, possibly seeking to punish participants found to be spreading false information about the financial situation of European banks. The move is a direct response to the proliferation of rumours this week that banks in France and other countries could be imperilled if the sovereign debt crisis worsened. Regulators were forced to publicly dispelled those suggestions amid efforts to calm investors.

Analysts have suggested the volatility in European financial stocks does not reflect the capital level of banks, which has stabilized over the past three years. Some troubling signs have emerged though, including a spike up in overnight lending from the European Central Bank to financial institutions. .That trend, which is at its highest point in three months, is seen as an indication that some lenders need short term access to cash.

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Though bank stocks in Europe and the U.S., and to a lesser extent Canada, have alternated between steep drops and subsequent rallies in recent trading days, taken over the past few months they are on a downward slide.

Charles Dallara, managing director of the Institute of International Finance Inc., a Washington-based association of more than 300 major global banks, said the market reaction does not reflect the reality of financial institutions. Banks carry more capital than they did during the crisis of 2009 and are more stable.

"I think the markets are overreacting to some serious but manageable problems in the European economic and financial landscape," Mr. Dallara said, referring to concerns about the U.S. debt downgrade last week and the ongoing European woes. "If you look at capital structures, if you look at performance, you really don't find anything to be alarmed about with regard to European financial institutions."

With a report from David Berman

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