Why did HBOS need to be rescued by Lloyds TSB? Where should the finger of blame point?

For many, the answer is clear - Mayfair.

The streets of London W1 house some of the world’s biggest hedge funds, which now stand accused of bringing HBOS and other financial institutions to their knees.

Their weapon? Short-selling, the process of betting that a share price will fall.

Their critics argue that short-sellers helped to drive down the HBOS share price at the start of the week. After the collapse, HBOS management rushed to sell the bank. Ergo, short-sellers are to blame for the sale and the thousands of job losses that will result. “Greedy pig”, screamed the Daily Mirror front-page headline yesterday alongside a picture of the boss of a leading hedge fund that uses short-selling.

The accusation is almost as old as shareholder capitalism. In 1609 Isaac Le Maire, a Dutch trader, was blamed for causing a drop in the share price of the Dutch East India Company by short-selling its stock. The practice was promptly banned - for a while.

In 1929 short-sellers were blamed for driving down share prices in the Wall Street crash. The practice was banned - for a while.

Yesterday the Financial Services Authority heeded the latest calls and introduced a ban on short-selling of financial stocks - until January.

The American authorities are under intense pressure to follow suit. John Mack, the chief executive of Morgan Stanley, the Wall Street bank, is urging the Government to act to stop the “outrageous” short-selling of stocks in banks such as his.

The irony here is that Morgan Stanley makes money lending shares in other companies to hedge funds to short-sell.

Hedge funds have insisted that a ban would be ineffective, if not counterproductive, and complain that they are being used as scapegoats. The HBOS share price would not have collapsed on Monday and Tuesday if the market did not have fundamental concerns about the company, they say.

The very act of short-selling does tend to depress a share price, just as buying stock in any volume should increase it. But the effect should, in both cases, be temporary, unless the view of other investors is changing.

Many investors did view HBOS as having serious challenges. And yesterday the company admitted that they were right. The concerns related largely to HBOS’s ability to raise the funds it needed from the so-called wholesale money markets.

Only half the money it lends in mortgages is funded from savers’ deposits; the rest it borrows from other financial institutions, with loans of varying durations.

Since the onset of the credit crunch these wholesale funding markets have dried up. Banks have become nervous about their own future and suspicious of other banks. Rather than lending out spare cash they do not need for a month or two to other banks, they are putting it into safe but low-interest government bonds.

They can be persuaded to lend out the cash only if they are offered much higher interest rates than are available on government bonds.

The effect can be seen in Libor, a measure of the interest rates that banks are charging each other. This shot up at the start of the credit crunch, making life very difficult for banks that depend on these wholesale markets. Because banks’ funding costs rose, they passed on the increase to mortgage payers.

Libor is only an average. If a bank is thought to be risky, other banks will charge it a higher interest rate. Some banks are seen as so risky that the rates become punitive. That is what happened to Northern Rock. It reached the point where it could no longer fund itself and was bailed out by the Government.

Northern Rock was particularly vulnerable because the wholesale markets accounted for three quarters of its funding. One hedge fund manager told me that he identified the weakness of Northern Rock’s business model five years ago and started short-selling. For four years the share price just kept on going up and he lost a lot of money. But he was finally proved right and made it all back when Northern Rock collapsed.

Short-selling was not the cause of Northern Rock’s collapse. Indeed, you could say that the problem was not too much short-selling, but too little. If there had been more short-selling during the boom it might have forced Northern Rock’s management to be more cautious and saved it from its fate.

In normal circumstances, short-selling plays a valuable role in creating efficient markets, as Alistair Darling, the Chancellor, has been keen to point out.

These are not normal circumstances, however. Several leading financial institutions have already gone under, causing huge losses for investors and lenders. Nobody wants to be hit by the next one to fall.

Banks are dependent on confidence. Without it they die. And confidence is very fragile at the moment. A sharp fall in a bank’s share price can undermine confidence among its depositors and lenders. This weakens the share price in a potential vicious cycle.

Short-selling of shares in an industrial company may be uncomfortable. But it is not dangerous. Short-selling of shares in a bank in normal times should not be a problem.

But, at the moment, the authorities believe that short-selling introduces an unnecessary risk of undermining banks that could otherwise withstand the storm.

The more modest curbs on short-selling introduced on both sides of the Atlantic appear to have had little impact. An outright ban may not do much good either. But it is surely worth a try.

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