What Is Short Selling and How Does It Relate to the Banking Crisis?

Short selling, which essentially involves betting that a stock price will fall, often gets a bad rap in the investing world. Oftentimes, short sellers are seen as predators, pouncing on companies that are experiencing financial difficulty and exacerbating the problem.

Read: 3 Things You Must Do When Your Savings Reach $50,000

The recent demolition of regional bank prices — including the complete failure of some — has been blamed on short sellers in some circles. But, what is short selling, and how does it relate to the banking crisis? Read on to learn more.

What Is Short Selling?

When you “short” a stock, you sell shares that you don’t own. As you can’t technically sell something you don’t have, you must borrow any shares you sell in a short transaction. After you sell them in the open market, you’ll be responsible at some point to replace them by buying them back. Ideally, the share price will have fallen from the time you sold it, meaning you can buy it back at a lower price and pocket the profit. If the share price has risen, on the other hand, you might have to buy your stock back at a loss.

How Can Short Selling Affect a Company’s Stock Price?

The technical details of short selling and the effect it can have on the market are two different things.

While borrowing 100 shares of Tesla and selling it short won’t have any effect on the stock’s price, professional short sellers are a different breed. These types of institutional traders usually combine large-scale stock selling with very public campaigns outlining why a company’s stock price shouldn’t be so high, in their opinion. This is what often gives short sellers a bad reputation, as they are seen as driving down a stock’s price for their own gain.

But the information they provide to the public often reveals legitimate problems within a company. This could compel other investors to dump the stock as well — or even short it themselves.

What Happened To Regional Bank Shares in 2023?

The first domino to fall in the regional bank crisis of 2023 was Silicon Valley Bank, which failed on March 10. This was followed almost immediately by Signature Bank, which fell into FDIC receivership on March 12. First Republic Bank then failed on May 1.

Not surprisingly, other regional bank shares sold off sharply in response. Shares of PacWest Bancorp, for example, initially fell from $26.68 on March 8 to $9.75 on March 13. It then continued to drift lower until reaching an all-time low of $2.48 a few days after the First Republic Bank failure.

The FDIC did its job in the case of each of the bank collapses and did not prevent financial contagion from spreading to actual depositors. Although FDIC insurance technically only covers up to $250,000 per depositor per type of account, the government announced that in the cases of these bank failures, all accounts would be protected.

In the cases of Silicon Valley Bank and Signature Bank, the Federal Reserve dubbed these actions “systemic risk exceptions.” This suggested that they may not extend to any further bank failures. The case of First Republic Bank was a bit different, as the FDIC already had JPMorgan Chase Bank lined up to take over all assets and deposits of the bank at its time of failure.

These actions helped restore confidence in the banking system, and helped regional bank shares to recover a bit from their low stock prices.

What Were the Reasons Behind the Bank Failures?

The reasons behind these various bank collapses were complex.

One of the main causes was sharply rising interest rates. This forced banks to pay higher rates on their deposits than they were taking in from their loan portfolios. Once word spread that some of these banks were in an upside-down position, depositors began withdrawing their money in droves.

As banks never keep enough money on hand to cover all of their physical deposits, the banks didn’t have enough cash on hand to meet depositor demands. This imbalance set them up for insolvency.

Do Short Sellers Ever Get Burned?

One of the risks of selling a stock short is that you can get caught up in a short squeeze. This occurs when the share price of a company gains rapidly in price, forcing short sellers to cover their positions to limit their losses. But all of this buying back of shorted shares adds further buying pressure to a stock. This pressure drives the price up even higher and forces even more short covering.

There have been a number of notable short squeezes in the market over the past years. Most known would be the so-called “meme stocks” like GameStop and AMC Entertainment. Short sellers that had profited in prior years got hit hard in these notable short squeezes, which saw GameStop skyrocket 400% in a single week in 2022.

The Bottom Line

Short sellers did not cause the financial conditions that pushed three regional banks into failure in 2023. However, short sellers likely increased the magnitude of the fall in the shares prices of those banks and others, generating massive profits for them along the way.

FAQ

Here are the answers to some of the most frequently asked questions regarding short selling.

• How does short selling work?

  • Short selling involves selling stock that you have borrowed. After selling it, you are responsible for replacing it by buying it back. Typically, investors will do this when the stock price has fallen so they can pocket the profit.

• What is short selling with an example?

  • Short selling involves selling shares you don’t own.

  • An example of this would be when an investor finds a stock that they believe will decline in value. They borrow 50 shares and sell them for $100 each. Their total sale would be $5,000.

  • When the price does drop, to $50 a share, they buy the shares back to repay the loan. The $2,500 would be their profit.

• Why is short selling illegal?

  • Short selling is legal and is an investment strategy used by experienced investors.

This article originally appeared on GOBankingRates.com: What Is Short Selling and How Does It Relate to the Banking Crisis?