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

Abstract

As a consequence of the suspicion that margin loans had been a key element of the stock market boom and crash in the late 1920s, the Federal Reserve Bank was empowered to regulate margin lending with the Securities and Exchange Act. However, there 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.

Keywords: asset pricing, asset price bubbles, margin loans, margin regulation

JEL Classification: D82, G12, G18, G21