By Chris Prentice

NEW YORK Federal prosecutors in Washington are looking into short seller activity around the recent volatility in U.S. bank shares sparked by the failure of three regional lenders since March, a source familiar with the matter said.

Short sellers, traders that profit by betting shares will fall, have come under scrutiny over the past week as government efforts to steady the sector have faltered and investor fears over the health of regional lenders have deepened.

Their activity around the banking crisis is an "area of interest" for the Justice Department, which is looking for potential securities market manipulation, the person said.

Other regulators are also assessing potential market manipulation by short sellers, Reuters reported last week, but the scrutiny by criminal prosecutors, which has not been previously reported, raises the stakes for potential wrongdoers.

U.S. Securities and Exchange Commission chair Gary Gensler and California regulators have said they are watching for any potential misconduct.

The standard for launching a formal probe is very high and it is unclear whether prosecutors would ultimately bring any charges, the person said.

A spokesperson for the Justice Department did not respond immediately to request for comment.

The KBW Regional Banking index has slumped 24% since the day before regulators shuttered Silicon Valley Bank, the first lender to collapse, on March 10.

Short sellers arrange to borrow shares they consider overvalued and sell them in the hopes that if the price drops they can repurchase them for less and pocket the difference.

They have profited from the banking crisis, reaping $1.2 billion in paper profits during the first two days of May, according to data from analytics firm Ortex. A brief rebound in bank stocks on Friday squeezed some of those negative bets.

Critics say short sellers hurt companies, but short sellers and advocates say they act as an important check on public firms.

Last week, the American Bankers Association urged the SEC to probe "significant" short sales of bank shares that did "not appear to reflect the issuers’ financial status," including some that followed favorable earnings reports, the group wrote.

"We have also observed extensive social media engagement about the health of various banks and the sector generally that appears disconnected from the underlying financial realities," it added.

Since at least 2021, the Justice Department and the SEC have been investigating potential manipulation by short sellers and hedge funds around the publication of negative research reports.

The source did not say whether the latest interest in bank stocks was related to that pre-existing probe.

(Reporting by Chris Prentice; editing by Michelle Price and Sonali Paul)