Just over a week ago the SEC took an "emergency action" and banned all short selling on 799 financial companies.

Short sellers borrow stock with the aim of selling it, then buy it back at a lower price, hoping to pocket the difference. The commission said short sellers add liquidity to the markets during normal conditions, but recent unbridled short-selling has contributed to the recent tailspin in the stock market.

What the SEC didn't bother to consider was that short-selling also adds liquidity during the tailspin as well.
The SEC has made things worse, not better.

The most direct way that the SEC ban has damaged the markets is surprisingly in the bond market.

The Securities and Exchange Commission's ban on short selling of financial stocks has effectively shut down much of the convertible-bond market, a crucial area of financing for struggling companies.

Convertible securities are essentially bonds that can be exchanged for stock in the future. It's a relatively small market with less than $400 billion in securities outstanding, according to market participants, a fraction of the total for investment-grade bonds. But in times of stress, struggling companies turn to convertibles in order to raise capital when a share price has fallen.

Battered financial companies, such as Bank of America Corp. and Citigroup Inc., sold billions of dollars in convertible debt earlier this year. Of the roughly $60 billion in convertible securities issued in the first eight months of this year, 65% was from financials, according to research by analysts now at Barclays Capital.

"At the beginning of the year it was the 'convert' guys that provided the liquidity to all these institutions. Now the SEC is literally shutting the market down," says Adam Stern, chief executive at hedge-fund manager AM Investment Partners.

A $400 Billion market is nothing to sneeze at, and shutting it down at a time like this is enough to cause many financial institutions to go under.
It's amazing how everyone is running to the government to fix the financial markets, when it is the government who has been screwing it up.

The convertible bond market might be the most dramatic way that the short-selling ban has damaged the markets, but its hardly the most obvious. Consider the $1.7 Trillion hedge fund market.

The short-selling ban is taking the ‘hedge’ out of hedge funds. The Securities and Exchange Commission has banned short sales of roughly 950 financial-related stocks until Oct. 2...
With their hands tied on those stocks and the algorithms that do much of their trading running into technical hitches, many quantitative and other ‘market neutral’ hedge funds are drastically reducing trading activity...
‘There are very, very few short-only funds on Wall Street, so the ban mainly removed long/short funds from the market,’ said Dan Mathisson, head of the algorithmic trading unit at Credit Suisse...
‘If they can’t put on their short positions, they can’t put on their long positions, either. It’s just breaking down a lot of their models, and the end result is they’re walking away. A lot of funds are reducing the size of their books.’

Sure, hedge fund managers aren't exactly the most sympathetic figures out there, but "reducing trading activity" also means less liquidity in the market, and thus pushing banks towards bankruptcy.

The final way that this short-selling ban has damaged the financial markets is with credit-default swaps. I haven't been able to find a article describing it, so I'm going to have to wing it.
Many CDS holders just flat out don't have the capital to cover the losses in the event of a credit default. They hedge for this in their models by shorting the stocks that they own the swap on. At least that was the way it worked before the SEC ban.

Now that model is broken. Now the swap holders can no longer hedge their CDS bet. With financial institutions going broke right and left, triggering credit default events, these swaps are being defaulted on as well. Given the size of the CDS market, there is a real danger of the derivatives market freezing up altogether.