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What is the Link Between Margin Loans and Stock Market Bubbles?

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  • Markus Ricke

    (University of Muenster)

Abstract

As a reaction to the general suspicion that margin loans had been a key element of the stock market boom and crash of the late 1920s, the Federal Reserve Bank was empowered to regulate margin lending with the Securities and Exchange Act. The efficacy of the Federal Reserve's margin policy has extensively been studied empirically. However, there still exists no formal rationale for the regulation of margin lending. In this paper, we demonstrate in a principal-agent model that the availability of margin loans can cause the development of a stock market bubble through inducing investors to pay more for a stock than its fundamental value. We show that the emergence of a margin loan induced bubble can be ruled out by an initial margin requirement and thus provide a formal rationale for margin regulation.

Suggested Citation

  • Markus Ricke, 2003. "What is the Link Between Margin Loans and Stock Market Bubbles?," Finance 0311014, EconWPA, revised 17 Dec 2004.
  • Handle: RePEc:wpa:wuwpfi:0311014
    Note: Type of Document - pdf; prepared on WinXP; pages: 50; figures: 3
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    More about this item

    Keywords

    asset pricing; asset price bubbles; margin loans; margin regulation;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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