Credit default swaps and the UK 2008–09 short sales ban

Most studies of the short sales ban of UK financial stocks from September 2008 to January 2009 fail to control for the UK’s worst ever banking crisis and the underlying increase in risk. This paper studies the ban’s impact on the 13 large financials with credit default swaps (CDS) and 20 smaller stocks without CDS. The results reveal that returns of banned stocks Granger cause CDS returns in the pre- and post-ban periods, but causality runs from CDS to stock returns during the ban period. Underlying risk proxied by the CDS probability of default increased during the ban and the immediate pre- and post-ban periods which highlights an endogeneity problem ignored in some studies. This increased risk provides a plausible rationale for why CDS and related equity bid-ask spreads - which increased during the ban period – failed to fall significantly in the post-ban period. Panel regression results indicate that probability of default was an important economic determinant of stock bid-ask spreads during the ban period. Finally, our results suggest that the ban offered direct price support for the smaller non-CDS stocks during the ban period and indirect support for CDS stocks from their pre-ban to their post-ban levels.