Leverage and beliefs: Personal experience and risk taking in margin lending

What determines risk-bearing capacity and the amount of leverage in financial markets? This paper uses unique micro-data on collateralized lending contracts during a period of financial distress to address this question. An investor syndicate speculating in English stocks went bankrupt in 1772. Using hand-collected information from Dutch notarial archives, we examine changes in lenders' behavior following exposure to potential (but not actual) losses. Before the distress episode, financiers that lent to the ill-fated syndicate were indistinguishable from the rest. Afterwards, they behaved differently: they lent with much higher haircuts. Only lenders exposed to the failed syndicate altered their behavior. The differential change is remarkable since the distress was public knowledge, and because none of the lenders suffered actual losses – all financiers were repaid in full. Interest rates were also unaffected; the market balanced solely through changes in collateral requirements. Our findings are consistent with a heterogeneousbeliefs- interpretation of leverage. They also suggest that individual experience can modify the level of leverage in a market quickly.