Bank credit, consumption risk, and the cross-section of expected returns

Although the consumption capital asset pricing model has an unmatched theoretical purity for assets’ risk, the empirical failure of the model stands as a central finding in asset pricing. In an effort to resuscitate consumption-based asset pricing model, we develop and estimate new conditional consumption capital asset pricing models with bank credit growth and bank credit cycle as conditioning variables. Rather than assuming the constant factor loadings of asset returns on consumption growth, we model time-varying consumption beta as a function of bank credit growth or bank credit cycle. We find that our specifications explain satisfactorily the variation in stock returns across the 25 Fama–French portfolios. Moreover, the strict statistical tests on risk price and explanatory power show that the models compare favorably with other renowned asset pricing models. These findings document that the dispersion of expected returns is the outcome of the degree of reward for consumption risk, thereby being consistent with asset pricing theory.