Leverage in financial markets is not constant over time. Lending is typically pro-cyclical – high and increasing in good times, and much lower when asset prices fall. For example, when the stock market crashed after Lehman’s bankruptcy in 2008, “haircuts” increased sharply and the volume of collateralized lending collapsed. Pro-cyclical “leverage cycles” affect the risk-bearing capacity of financial intermediaries and can contribute to large changes in asset prices. The source of these important changes is less clear.
Margin loans in 18-century Amsterdam
What determines risk-bearing capacity and the amount of leverage in financial markets? Using hand-collected data from notary archives, we focus on margin loans in the 18-century Amsterdam stock market. When an investor syndicate speculating in Amsterdam in 1772 went bankrupt, many lenders were exposed. In the end, none of them actually lost money. Nonetheless, only those at risk of losing money changed their behavior markedly – they lent with much higher haircuts. The rest continued as before. The differential change is remarkable since the distress was public knowledge. Overall leverage in the Amsterdam stock market declined as a result.
Our results strongly suggest that individual risk taking can change substantially as a result of personal experience, even without changes to wealth – and that such changes do not only arise among retail investors, but among sophisticated market participants. Importantly, we also show that personal experience can change investor behavior in a major way, causing significant shifts in aggregate outcomes such as market-wide leverage.