Short sellers aren't the problem. Bank stability is

Bloomberg News

Vultures are some of the most highly evolved vertebrates in the animal kingdom. Their digestive tracts have a pH so low and corrosive that almost any microorganism a vulture eats is either killed on impact or isolated in its digestive tract — it's so corrosive, in fact, that if a vulture eats a dead animal that contains lead bullets, the bullets will dissolve in the vulture's digestive tract and kill the vulture via lead poisoning.

All of that may sound pretty gross, but keep in mind that vultures play a vital role in the ecosystem, limiting the spread of disease among living animal populations and hastening the biodegradation of animal carcasses into food that goes back to the bottom of the food chain. They play a role that may be unseemly, but it's nonetheless vital. 

Short selling kind of works the same way. Market participants are all looking for the same thing: dislocations between a company's actual value and perceived value. If a company is actually pretty strong and has the potential to grow but undervalued, investors would buy that stock and profit if their hunch turns out to be correct. 

Short selling offers investors the same opportunity but in reverse — if a company is overvalued relative to its fundamentals, there is money to be made watching that valuation come back to earth. The reason that can be healthy is because having those vultures watching over the market acts as a check on overvaluations, which can lead to destructive asset bubbles.

As we've all seen, short sellers are back in the news after a week of dramatic volatility in the stock valuations of several regional banks. Earlier Tuesday a number of those stocks were declining — led by PacWest Bancorp, which announced a dividend cut Monday — after those same stocks rallied late last week … after declining dramatically a week ago. Short interest in those next-most-wobbly banks has ballooned; short sellers earned a reported $1.2 billion on the failures of Silicon Valley Bank, Signature Bank and First Republic over the last several weeks.

The reason the vultures have been circling both those failed banks and their still-living peers is the same: an overreliance on long-dated underwater securities on their balance sheets. A wise man once said that stock valuations are imperfect proxies for bank solvency — banks capitalize themselves primarily via deposits rather than stock offerings. Bank stock values can ebb and flow, but as long as the fundamentals are strong banks can live to fight another day and the vultures will turn their attention to another rotting carcass in the financial system.

I realize that take may seem rather blithe, and I'm not entirely confident that it will stand the test of time. Short selling may play a vital role in market discipline, but short sellers can also hasten the demise of companies that aren't dead yet. That's why several bank trade associations are asking the Securities and Exchange Commission and White House to either put a temporary stop to shorting bank stocks or at the very least root out any market manipulation that could be lurking in the regional bank space. 

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But I can think of a more productive use of supervisory firepower: Regulators should proactively and publicly use their tools to make those banks better-capitalized and therefore resilient. PacWest, in my opinion, did the right thing by cutting its dividend. PacWest CEO Paul Taylor called the dramatic cut — from $0.25 per share to only $0.01 per share — "a prudent step to accelerate our plans to build capital." The bank's shares lifted Monday and then took a hit today, only to rally again by the time of publication — and who knows what tomorrow will bring. But reinvesting its own profits will eventually make the bank more fundamentally sound and drive the buzzards away — in other words, don't get mad, get even.

Regulators can also regain some credibility by compelling banks that aren't already with the program to get the memo. The Federal Reserve did something like this recently by issuing an enforcement action against Du Quoin State Bank in Illinois, requiring it to get ahead of its interest-rate-risk problems before it's too late. 

Another thing regulators can do is make it easier for banks — particularly banks of similar size — to merge. This is of course antithetical to the Biden administration's stated goal of reconsidering the process around bank mergers with an eye toward customer protection and competition. But on the other hand, a failed bank does nothing to protect customers or increase their options, and if the fastest way for two wobbly banks to get stronger is for them to merge, that should be a realistic option for boards of directors and regulators to consider.

Market manipulation is illegal, its practitioners should be punished, and whether that manipulation comes in the form of short selling or pump-and-dump schemes is immaterial. But drawing a clear distinction between market manipulation and market participation can be time-consuming and ultimately futile, and in this case I think it's probably a dead end. But bank managers and regulators have the power to keep short sellers at bay. They just have to play the long game.