Margin Lending and Information Production

Abstract

Many types of financial institutions borrow using margin loans. I propose a new explanation for the widespread use of these contracts in the financial system. In my model, margin loans prevent lenders from producing too much information about borrowers' assets at origination, by forcing borrowers to liquidate prior to maturity following a negative shock. However, while margin loans deter information production in the primary market, they induce it in the secondary market, depressing asset prices. The analysis can rationalize policies that curb margin lending in normal times and support it in periods of market stress.

Keywords: Margin lending, information production, adverse selection, optimal security, market equilibrium

JEL Classification: G23, G32, G28