Chicago Booth’s Zhiguo He: Leverage & Panic Sales Cause Market Crashes

Poets &Quants’ Professor of the Week Zhiguo He of the University of Chicago’s Booth School of Business

Lately, we’ve witnessed a fire sale in the markets.

Less than a month after hitting their all-time highs on February 19th, the Dow Jones Industrial Average and the Standard & Poor’s 500 and Nasdaq Composite indexes all had fallen beyond the 20% decline many market practitioners consider a bear market in stocks. This is the first bear market since the 2008-2009 financial crisis.

The plunge was driven by fears the coronavirus pandemic would wreak havoc on the global economy. Hopes that the Federal Reserve and the Trump Administration would ride to the rescue with monetary and fiscal salvation thus far have not staunched the selling.


Every stock market selloff or crash has different causes, but many have two basic things in common: leverage and panic. Speculating with borrowed money—be it through derivatives or margin loans—and then forced liquidations of securities through fire sales have been the hallmark of market crashes past and present.

Poets&Quants’ Professor of the Week, Zhiguo He of the University of Chicago Booth School of Business, dug deep into the spectacular stock bubble and sell-off that occurred in China in 2015 to try to discern the role leverage and fire sales play in stock market crashes. His study, the first of its kind to examine empirically how individual investors acted in the heat of a market crisis, backs up the widespread presumption that leverage makes periodic market fire sales worse.

The working paper, whose most recent version appeared in September 2018, was co-authored by Jiangze Ban of the University of International Business and Economics in Beijing, Kelly Shue of the Yale School of Management, and Hao Zhou of the School of Finance at Tsinghua University in Beijing. 


To study the dynamics of market crashes, He and his co-authors tracked hundreds of thousands of individual brokerage accounts in China over the three-month period from May to July 2015. Since January of that year, the Shanghai Stock Exchange had gained more than 2,000 points, soaring 67%. But then in mid-June, it rapidly reversed course, and the subsequent crash wiped out nearly 40% of its value.

The sell-off was triggered by an announcement by the China Securities Regulatory Commission (CSRC), the regulator of the Chinese stock market, that it would tighten rules on certain forms of margin lending. Many individuals borrow money on margin and invest it, using the stocks they own as collateral. If the stock drops to a certain level, the brokerage firm that lent the money might issue a “margin call,” under which the investor has to pay up or the firm would sell the shares to cover the loan. When that happens in the midst of a market sell-off, the cascading margin calls can set off a fire sale. That’s what took place in China in 2015, He and his co-authors found.

But in China, there were two types of margin lending, one tightly regulated by the CSRC and financed by established brokerages, the other, unregulated and “shadow financed” by entrepreneurial fintech providers. 


Investors who had regulated margin accounts needed to have a certain amount of assets and a maximum level of leverage, which if exceeded would require the brokerage firm to take over the account. Unregulated, shadow-financed margin accounts had no asset requirements and maximum leverage limits were negotiated between the brokerage and the client. 

“Shadow-financed margin accounts contributed more to the market crash. The leverage of [regulated] brokerage accounts remained low,” the researchers write.

”The announcement of regulations that would tighten leverage constraints for shadow-financed margin accounts led to large upward jumps in selling intensities for shadow accounts (and not for brokerage accounts),” the researchers write. “Stocks disproportionately held by highly-leveraged margin accounts experienced larger percentage declines relative to other stocks.”


He and his co-authors found striking parallels with the U.S. stock market crash of 1929, which also followed a period of leverage-fueled speculation. Citing John Kenneth Galbraith’s classic book, The Great Crash, He and his co-authors write, “Margin trading thrived in the period leading up to the 1929 crash, with outstanding margin credit rising from about $1 billion in the beginning of 1920s to $17 billion in the summer of 1929. “ 

Both systems, they noted, “lacked market-wide regulations of initial margins and minimum margins.” And in both cases, margin calls triggered fire sales that wound up pushing stocks lower, though the 1929 crash was deeper and had more lasting effects. He’s research, however, shows the commonality between these two distant events and takes our understanding of market crashes a big step forward.

He, 42, is the Fuji Bank and Heller Professor of Finance and co-director of the Fama-Miller Center at Chicago Booth, and a Research Associate at the National Bureau of Economic Research. His research focuses on financial markets, from the role of financial institutions in the global financial crisis of 2008 to Chinese financial markets to cryptocurrencies and blockchain. He teaches classes in corporate finance and the Chinese economy and financial markets, as well as research seminars for Ph.D. students.

Having earned bachelor’s and master’s degrees in economics and finance from Tsinghua University, he got a Ph.D. in finance from the Kellogg School of Management at Northwestern. He has taught at Chicago Booth since 2008.

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