Officials suspect one possible scandal on crazy bank stock movements

U.S. officials said they were monitoring the banking sector for signs of fraud back in March.

While investors fret about a contagion in the banking industry taking down the entire sector, U.S. regulators are investigating the possibility that "market manipulation" is what's actually behind tanking bank stocks.

A spike in short-seller activity and volatility in bank stocks has drawn the attention of federal and state officials, Reuters reported, citing a source who also said that the banking sector had "strong fundamentals" and "sufficient capital levels."

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"State and federal regulators and officials are increasingly attentive to the possibility of market manipulation regarding banking equities," the source told Reuters.

The source also pointed out that the U.S. Securities and Exchange Commission warned in March that it was carefully watching market stability and would prosecute any form of misconduct during the collapse of Silicon Valley Bank and Signature Bank -- two regional banks that collapsed following unprecedented bank runs.

There has been some speculation that regulators could resort to pausing the ability of investors to bet against bank stocks through short selling.

"I think there will be a blanket regulation preventing the shorting of bank stocks for a week, a month, who knows. Anyone with half a brain in Washington can see this will destroy the banking system until a recession cleanses the system," Richard Bove, chief financial strategist at Odeon Capital Group, told TheStreet.

"The shorts have done the banking system a favor [by forcing out weak banks]. Regulators didn't do their jobs."

The Federal Reserve acknowledged simmering risks in the banking sector, following the failure of Silicon Valley Bank and the closure of Signature Bank in early March, as well as the sale of First Republic (FRC) - Get Free Report to JPMorgan earlier this week, but insisted the system is "sound and resilient" as it delivered its 10th consecutive rate hike in Washington this week.