A Margin Call Gone Wrong: Credit, Stock Prices, and Germany's Black Friday 1927

Abstract

Leverage is often seen as villain in financial crises. Sudden deleveraging may lead to fire sales and price pressure when asset demand is downward-sloping. This paper looks at the effects of changes in leverage on asset prices. It provides a historical case study where a large, well-identified shock to margin credit disrupted the German stock market. In May 1927, the German central bank forced banks to cut margin lending to their clients. However, this shock affected banks differentially; the magnitude of credit change differed across banks. Using the strong connections between banks and firms in interwar Germany, I show in a difference-in-differences framework that stocks affiliated with affected banks decreased over 12 percent during 4 weeks. Volatility of these stocks doubled. Relating directly bank balance sheet information to asset prices, this paper finds that a one standard deviation decrease in lending to investors increased an affected stock's volatility by 0.2 2 standard deviations. These results are robust to the problem that banks' lending decisions may be influenced by asset prices. The Reichsbank threatened banks to cut their short-run funding. Using the differences in exposure towards this threat, an instrumental variable strategy provides further evidence that a sharp decrease in leverage may lead to stock price fluctuations.