Winter 1989 Do Margin Requirements Matter? Evidence from U.S. and Japanese Stock Markets The OctoBer 1987 stock market crash has prompted requirements as a policy tool. regulators to seek out policy tools that can control The effect of margin requirements on the U.S. stock aBrupt stock price changes and market volatility. The market has been the focus of many empirical studies. sudden 23 percent drop in stock prices in a single day Most earlier studies concentrated on the effect of mar­ was a reminder that the market is often dominated By gin requirements on the level of the market: they found investors whose actions may violate economists’ rules that increases in margin requirements decreased stock of rational behavior. One possiBle curB on volatility and prices while decreases in margin requirements Boosted “irrational” speculation that has recently generated stock prices, although both effects were weak.2 Only some interest is the use of margin requirements. This two of the earlier studies, one by Douglas (1969) and article considers whether margin requirements are in another By Officer (1973), concentrated on stock mar­ fact an effective policy tool. It reviews the evidence on ket volatility.3 Both authors found a negative associa­ the relationship Between margin rules and volatility in tion Between the level of official margin requirements the United States and offers new evidence drawn from and stock market volatility. Recently, one of the authors the Japanese experience with margin requirements. of this Quarterly Review article corroBorated the find­ The function of margin requirements in the stock ings of Douglas and Officer and extended the analysis market is to restrict the amount of credit that Brokers By examining excess volatility— volatility that cannot and dealers can extend to their customers for the pur­ be explained by the variaBility of the economic environ­ pose of Buying stocks.1 The U.S. Congress first ment—and long-run deviations of stock prices from imposed official margin requirements on stock transac­ their fundamental values. He concluded that in periods tions in 1934, after a period of great turBulence in the stock market. Congress Believed that the margin 2See Jacob Cohen, “ Federal Reserve Margin Requirements and the Stock Market,” Journal of Financial and Quantitative Analysis, restrictions would rid the market of highly leveraged September 1966, pp. 30-54; James Largay, “100% Margins: speculators and hence lead to greater staBility. The Combating Speculation in Individual Security Issues,” Journal of Finance, September 1973, pp. 973-86; and Dudley Luckett, “On the Federal Reserve, given jurisdiction over the appropri­ Effectiveness of the Federal Reserve's Margin Requirement," Journal ate level of margin requirements, changed the official of Finance, June 1982, pp. 783-95. Luckett finds that investors’ equity margin requirement twenty-two times Between 1935 in their margin accounts with brokers is affected negatively by a change in margin requirements. For further references, see Gikas and 1974 in response to what it perceived as excessive Hardouvelis, “ Margin Requirements, Volatility, and the Transitory speculation (or the lack of sufficient speculation) in the Component of Stock Prices,” Federal Reserve Bank of New York, market. In the last fifteen years, however, the Federal Research Paper no. 8818, to be published in the September 1990 American Economic Review. Reserve has effectively suspended the use of margin 3George Douglas, “ Risk in the Equity Markets: An Appraisal of Market 1For example, an official margin requirement of 60 percent implies Efficiency,” Yale Economic Essays, Spring 1969, pp. 3-45; and that an investor can only borrow up to $40 in order to buy a stock R. Officer, “The Variability of the Market Factor of the New York Stock worth $100. Exchange,” Journal of Business, vol. 46 (July 1973), pp. 434-53. Digitized16 for FRASERFRBNY Quarterly Review/Winter 1989-90 http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Winter 1989 of high margin requirements and in periods when mar­ margin policy. gin requirements increase, excess volatility is low and The article is organized as follows: We Begin by pre­ deviations from fundamentals tend to suBside.4 senting the theoretical link Between margin require­ These empirical findings have sparked a numBer of ments and volatility and then review the recent new studies disputing the effectiveness of margin rules. evidence on the effects of margin requirements on the These studies question the extent of the negative volatility of U.S. stock prices. The next three sections effect of margin requirements on actual volatility But do shift the focus to Japan. First, we review some institu­ not address the findings aBout the reduction of excess tional characteristics of the Japanese stock market and volatility and long-run stock price deviations from descriBe the regulation of margin trading. Next we esti­ fundamentals.5 mate the average relationship Between changes in The existence of such distinctly different points of margin requirements and changes in the momentum of view on the effectiveness of margin rules is partly stock prices over the sample period from 1951 through attriButaBle to the small sample that is availaBle for 1988. Finally, we extend the analysis to daily stock empirical analysis —a total of twenty-two changes in price volatility. The article concludes with a summary margin requirements. Because of the small sample of our principal findings. size, the negative association Between margin require­ ments and stock market volatility cannot be estimated Margin requirements and volatility: very precisely. Hence, the evidence is not sufficiently is there a precise theoretical link? strong to alter some economists’ Belief that regulatory Economic theory does not posit an exact and unam­ restrictions on the stock market are ineffective. Biguous link Between margin requirements and vol­ This article seeks to remedy the small sample proB­ atility But does suggest that an increase in margin lem and expand the availaBle evidence by examining requirements is likely to lower excess volatility. In order the Japanese experience with margin requirements. for margin requirements to reduce excess volatility, While margin requirements in the U.S. market changed they must impose a Binding constraint on the market twenty-two times over the last fifty-five years, margin activities of investors, and they must primarily restrict requirements in the Japanese market changed over the Behavior of destaBilizing speculators. one-hundred times in the last thirty-five years. The The first of these requirements would be met if the more frequent margin changes in Japan provide con­ alternative sources of credit availaBle to investors for sideraBle statistical power that should shed light on the the purpose of investing in stocks were more costly. In contested effectiveness of margin regulation. Further­ this case, margin requirements —official quantity ceil­ more, Japanese authorities, unlike their U.S. counter­ ings on the cheaper Broker-dealer funds —would con­ parts, administer margin requirements very actively strain the amount of total Borrowing for the purpose of even today. Hence the recent Japanese experience investing in stocks. This constraint would affect the with margin requirements may provide significant addi­ equiliBrium price in the market. In particular, one tional information aBout the contemporary impact of expects to oBserve that margin requirements bind dur­ ing periods when financial markets are not fully devel­ 4Gikas Hardouvelis, "Margin Requirements and Stock Market oped and alternative sources of credit are scarce or Volatility," this Quarterly Review, Summer 1988, pp. 80-89; and when the overall supply of credit in the economy is "Margin Requirements, Volatility, and the Transitory Component of tight. Stock Prices.” Many economists would argue, however, that even if sSee G. William Schwert, "Business Cycles, Financial Crises and margin requirements have a Binding effect on investors, Sjock Volatility," University of Rochester, William Simon Graduate School of Business, Working Paper no. 88-06, October 1988; such an effect is short-lived. Smart investors who like David Hsieh and Merton Miller, “Margin Regulation and Stock Market to oBtain financial leverage in order to invest in stocks Volatility,” Journal of Finance, vol. 45 (March 1990), pp. 3-30; Paul can find alternative sources of credit at no extra cost in Kupiec, "Initial Margin Requirements and Stock Returns Volatility: Another Look,” Journal of Financial Services Research, vol. 3 the long run and hence undo the constraining effect of (November 1989), pp. 287-301; Richard Roll, “ Price Volatility, the increase in margin requirements.6 This argument is International Market Links, and Their Implications for Regulatory only partly persuasive, however. In a dynamic market Policies," Journal of Financial Services Research, vol. 3 (November 1989), pp. 211-46; Michael Salinger, “Stock Market Margin with new entrants and exitors every period, even a con­ Requirements and Volatility: Implications for Regulation of Stock Index Futures,” Journal of Financial Services Research, vol. 3 (November d o r a related argument, see Michael Goldberg, "The Relevance of 1989), pp. 121-38; Raman Kumar, Stephen Harris, and Don Chance, Margin Regulations," Journal of Money, Credit and Banking, vol. 11 “The Differential Impact of Federal Reserve Margin Requirements,” (1985), pp. 521-27.