The Impact of Short Selling on Bank Holding Companies’ Loss Recognition and Risk Taking

Abstract

In this study we examine whether the Regulation SHO (Reg-SHO) affects bank loan loss provision practices and risk taking. We argue that when facing the heightened downward price pressure caused by the removal of short-selling constraints, pilot bank holding companies (BHCs) chosen for the SEC randomized experiment in Reg-SHO may delay loan loss recognition relative to both publicly traded and privately held control BHCs. In addition, to potentially offset the unrecognized expected loan loss that will be materialized in the future, pilot BHCs may take on additional risk. We find that pilot BHCs become more delayed in loan loss provisioning and engage in more risk taking in the pilot period compared to both control groups. We also find the increase in risk taking is most significant for pilot BHCs that delay loan loss provisioning the most in the pilot period. Finally, we find these pilot BHCs have the highest crash and tail risks in the recessionary periods. Our study provides insights to the current debate on the role of short selling in the banking industry.