“The dealer community, which had often lent more stock than they had in their possession (á la an airline that oversells seats on a particular flight)”
I was simply unaware that this was regular practice. The consequences for regulators and markets who, in dealing with stock brokers, don’t realise that they’re dealing with fractional reserve bankers (when a broker lends more stock than he holds, he’s essentially creating “money” against a fractional reserve, just as a banker does) are profound and, potentially, catastrophic. Indeed, a stock-broker who is issuing stock against a fractional reserve is no longer a broker in the literal sense (“no position”); he definitely has a position, even if it’s buried in convenient “lending” fictions.
The comparison with airline overbooking (and comparable practices for all other businesses that generate distressed inventory to liquidate: theatres, restaurants, etc.) is not the correct one; if you overbook a flight, the worst case outcome is a refund plus, typically, some additional compensation. Because distressed inventory is non-fungible, there’s minimal risk of knock-on impact. Securities markets exist to make securities fungible, consequently shortfalls will, for certain, have knock-on impacts and apparently uncorrelated risks will become correlated at exactly the wrong moment, much as we seeing with the current financial crisis generally.
If the pressures to reduce shorting end up creating an analogue of a liquidity shortage in banks, then this is one cure that may turn out to be a whole lot worse than the disease.