Margin practices and requirements during the National Banking Era: An early example of macro‐prudential regulation

• Published date: 01 March 2020
• Date: 01 March 2020
• DOI: http://doi.org/10.1002/rfe.1079
• Author: Bernard McSherry,Berry K. Wilson

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:210–225.

© 2020 University of New Orleans

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INTRODUCTION

This magnificent instrument of speculation

‐James K. Medbery, describing margin trading in 18701

Credit has fueled speculation since the earliest days of American securities markets, and throughout the period its use has been

alternately hailed and condemned by commentators, editorialists, and polemicists. A recurrent focus of criticism has been the prac-

tice of margin trading, an arrangement in which securities brokers finance customer trades collateralized through the retention of

the underlying securities. Popularly believed to be a contributor to market instability, margin loans have been blamed as a primary

cause of the stock market crashes of 1929 and 1987.2

The practice reached an early peak during the National Banking Era and shortly

thereafter it came to been seen as a major contributor to the many financial panics that plagued the pre‐Federal Reserve stock market.3

There is little consensus in the literature as to the role that margin requirements play in terms of weakening systemic stability, but

margin trading continues to be a subject of scholarly inquiry and the practice is regulated by the Federal Reserve System to this day.

Received: 14 February 2019

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Revised: 17 August 2019

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Accepted: 17 August 2019

DOI: 10.1002/rfe.1079

SPECIAL ISSUE ARTICLE

Margin practices and requirements during the National Banking

Era: An early example of macro‐prudential regulation

BernardMcSherry1

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Berry K.Wilson2

1NJCU School of Business,New Jersey

City University, Jersey City, NJ, USA

2Lubin School of Business,Goldstein

Academic Center,Pace University, New

York, NY, USA

Correspondence

Bernard McSherry, 52 Gillespie Ave, Fair

Haven, NJ 07704, USA.

Email: bernardmcsherry@aol.com;

bmcsherry@njcu.edu

Abstract

The New York stock market was plagued by a series of financial crises during the

National Banking Era, culminating in the Panic of 1907. The traditional view holds

that the crises were rooted in structural flaws related to trade settlement as well as

excessive and indiscriminate margin lending that remained unaddressed until the for-

mation of the Federal Reserve Bank. An examination of the historical record, how-

ever, shows that brokers sought to control contagion and spillover effects through

reform of the settlement process and by modulating margin lending rates and main-

tenance requirements according to macroeconomic conditions, counterparty credit‐

worthiness and market volatility. Using newly gathered archival data, we show that

the New York Stock Exchange enacted macro‐prudential regulations that may have

reduced the severity of crises during this period. By providing early evidence of pri-

vate sector responses to rising systemic risk, the paper addresses an important aspect

of early market microstructure.

KEYWORDS

counterparty risk, macro‐prudential regulation, margin trading, New York Stock Exchange

JEL CLASSIFICATION

G100; G230

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MCSHERRY and WILSOn

Margin trading had been an integral part of the New York securities markets since well before the Civil War, but it was not

until the especially severe Panic of 1907 that government officials acted upon the belief that margin lending increased market vol-

atility, as margin‐fueled purchases drove securities prices higher prior to the inevitable market crashes that occurred when margin

calls were made.4

The Hughes Committee, an investigatory body convened by the Governor of New York State in 1908, and the

Pujo Money Trust investigation of 1912 galvanized public opinion against margin trading, and in response to the outcry the New

York Stock Exchange (NYSE) imposed loosely enforced margin rules in 1913 in an attempt to forestall imposition of formal gov-

ernment regulations. The Federal Reserve Bank was established later that year, placing margin trading firmly in the crosshairs of

government regulators, culminating with the formal imposition of Federal Reserve Bank margin regulations in 1934.

In this paper, we argue that the regulators were mistaken to assume that margin trades increased market volatility to such a

degree that it threatened the financial system. The evidence shows that the members of the NYSE were incentivized to reduce

systemic risk, and they took active steps to prevent contagion effects set in motion by defaulting customers. Newly‐collected ar-

chival data reveals that the NYSE and its predecessor organizations enacted rules providing for minimum margin requirements

as early as 1836, and that they later evolved a complex and rigorous review of brokers' business practices that was designed to

discipline and expel brokers who were deemed to have engaged in “reckless and unbusinesslike” behavior.5

The discussion will

provide evidence that individual brokers actively monitored counterparty risk and adjusted interest rates and margin require-

ments in response to macroeconomic conditions, counterparty credit‐worthiness and market volatility. In an early example of

macro‐prudential regulation, these individual commercial practices were eventually adopted as industry‐wide policy.

The historical evolution of margin trading in the New York market has received scant scholarly attention, and it remains

firmly rooted in the popular imagination as a primary cause of stock market crashes and financial panics. It is perhaps unsur-

prising that such an important facet of the early stock market remains so poorly understood since sparse data exist concerning

specific rates and policies during the nearly century and a half oftrading that preceded the Fed's move to regulate margin prac-

tices. This paper addresses a central aspect of 19th century stock market microstructure that has long remained unexamined and

imperfectly understood.

The paper is organized as follows. Section 2 traces the development of Margin Lending practices and regulation in the

New York securities markets. Section 3 discusses the circumstances under which margin trading first became the subject of

governmental regulatory scrutiny. Section 4 offers evidence regarding the NYSE's efforts to regulate and enforce responsible

brokerage practices. Section 5 provides empirical results. Section 6 discusses the study's conclusions.

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MARGIN LENDING PRACTICES IN THE NEW YORK SECURITIES

MARKETS

Every clerk who could raise “a margin” was the owner of a little adventure in stocks or bonds

‐Hunt's Merchant's Magazine, 18536

In the United States, the practice of using borrowed stock for trading purposes appears to have first been used by Boston and

Philadelphia brokers as early as 1789, and shortly afterwards in the nascent New York stock market.7

During the first years of the

19th century, shares were typically bought on margin when subscribers to bank stock offerings pledged a substantial portion of the

stock to secure a loan from the issuing bank itself to pay for the security.

During the antebellum period, a preferred method of trading in New York was based on “time bargains”; seller's and buy-

er's option trades similar to futures arrangements, in which counterparties agreed to settle price differences up to ninety days

posttrade.8

Time bargains were desirable, at least partially due to the fact that the trades were lightly collateralized during a

period in which capital was scarce. Traders “on time,” were exposed to significant counterparty risk, however, and as a result,

time contracts tended to be expensive. A typical contract between counterparties required an initial deposit of 20% of a stock's

value and interest charges of 7% per annum.9

Under such trades a broker's obligations normallyended once a transaction had

been consummated; banks were left to provide custodial and settlement services. Time bargains freed brokers from the need

to obtain short‐term financing and all parties to the transactions gained additional time to gather documents and payments in

preparation for physical delivery.

Counterparty risk related to time bargains was an ongoing source of concern, and in the wake of the Panic of 1819, formal

Exchange regulations regarding time bargains first appear in the revised “Bye‐Laws” of the New York Stock & Exchange Board

(NYS&EB) adopted February 21, 1820.10

On April 4th, 1836, margin maintenance requirements were adopted: “Resolved that

contracts made at this Board of Stocks, other than Bank Stocks—either party may require 10% to be deposited either in money