Why do regulators ban short sales during crises?

Regulators regularly ban short selling during crises with the intention of stabilizing markets. The SEC halted short selling in the stocks of financial firms in U.S. markets between September 19, 2008 and October 8, 2008. Does banning short selling achieve this objective of stabilization? Short sellers generally receive bad press because they are betting on "declines" rather than "growth." Perhaps, the policy is more to reduce the ability of the informed and typically well-to-do from benefiting from the downturn. Imagine newspapers titled, "Wall Street's boom during Main Street's bust!"

The consequences of temporarily banning short selling are serious. First, short selling is important for market efficiency. Assume that investors with better information were not long the security in the first place. These investors know that the security is worth less and are willing to go short. The ban keeps the possibly better informed investors out of the market. Only the less informed owners of the stock are able to price the stock, but there information is less accurate. Less accurate prices mean policy makers and others have less accurate information about the health of the company or financial system at a time when accurate information is particularly important.

Second, short sellers cannot kill the company. Even if short sellers could force the price down to $0, the company will not fail unless the company cannot make required debt payments i.e. go bankrupt. The press often claims that short sellers can shake investor confidence. Short sellers do shake investor confidence by pricing into the market more negative information than the original investors probably had. For short sellers to really be able to cause unwarranted - erroneous - fear in the market requires an absence of other informed investors (including in the pull of short sellers) from taking the long position and keeping the stock price at an efficient level. Efficiency means the available information to traders is priced into the market.

Third, banning short sellers cuts liquidity. If short selling is integral to efficient prices, then why would investors want to buy stocks that are likely overvalued? Banning short selling defeats both those wanting to sell short and those wanting to go long. Less liquidity hurts existing shareholders who may want or have to reduce positions and sell into less liquid markets, resulting in a larger negative price impact.

Also, bans on selling certain companies short does not eliminate the ability to sell those companies short on other markets - like CDS or options markets.