Short-selling ban in Europe won't work. Here's why.

At the end of his tenure as chairman of the Securities and Exchange Commission, Christopher Cox said the biggest mistake of his term was to implement a three-week ban on short-selling bank stocks at the height of the financial crisis in 2008.

Cox’s admission—a view of short-selling that many market observers share—doesn’t mean that U.S. regulators won’t be tempted to introduce another ban as bank stocks get pummeled amid fears Europe’s debt woes could lead to another Lehman-sized financial crisis.

If worries about big banks escalate and start to spread to the U.S., regulators here could follow in the footsteps of France, Belgium, Italy, and Spain, which on Thursday agreed to ban bank and insurance stocks from short-selling—the practice of borrowing a stock and selling it in hopes of buying it back later at a cheaper price and pocketing the difference.

"One of the problems with the regulatory system is that it has to respond to the political system and politicians don’t necessarily understand markets,” says James Angel, associate professor of finance at Georgetown University. “When things get turbulent, the temptation is to blame the short sellers when they’re really not the bad guy. Banning short-selling doesn’t really do any good. All it does is signal that political leaders have run out of other tools to help.”

While the move by the four European countries may have brought some temporary calm for the stocks in the region’s ailing banking sector, critics blasted the temporary ban.

EDHEC-Risk Institute, a division of one of Europe’s top business schools, called the decision “a political smokescreen.”

Citing academic studies, the group said the move “is likely to be counterproductive, both directly by disrupting market functioning and degrading market quality at a most testing time, and indirectly by further fuelling defiance vis-à-vis sovereign states and the continued inability of their political institutions to address the causes of the current crisis.”

Robert Frenchman, a lawyer with Bracewell and Guliani, who represents financial services clients in regulatory matters, said that the markets are designed for both long and short investors and that banning short-selling “is an artificial constraint.”

He adds that governments should not be choosing whether to protect one sector and not another.

“Is there a justification for protecting banks in 2008 and not auto companies?” he says. “I don’t think the government should be in the business of making those kinds of determinations.”

Still, in cases of severe turmoil, a ban might be warranted, argues John Coffee, a securities law professor with Columbia University. U.S. regulators might be wise to implement a short-selling ban in two-week increments if it were limited to a dozen or so systemically important banks if they were in danger of failing, he said.

“I’m not saying it’s foolproof,” Coffee says. “But the U.S. cannot afford another too-big-to-fail institution hitting the rocks. There would be a huge firestorm if they had to bail out another financial institution again.”

Such an effort would be considerably more focused than the one SEC Chairman Cox approved four days after the collapse of Lehman Brothers in 2008. Short-selling was banned for 799 banks and other financial institutions.

The prohibition curbed the amount of shares borrowed during the three weeks, but stocks soon resumed their precipitous drop. The Wall Street Journal Friday cited a Credit-Suisse study that said prices on restricted stocks fell 21.8 percent during the period, while the broader market fell 22.8 percent.

Cox has since said that the costs of the ban outweighed the benefits.