Abstract
•Variables that predict labor income growth are candidate risk factors in the ICAPM.•Bank credit growth predicts labor income growth and business cycle variables.•Bank credit growth is priced even after controlling for well-known risk factors.•The ICAPM with bank credit growth performs very well in explaining stock returns.•These findings underscore the relevance of bank credit growth in stock pricing.
An ICAPM which includes bank credit growth as a state variable explains 94% of the cross-sectional variation in the average returns on the 25 Fama–French portfolios. We find compelling evidence that bank credit growth is priced in the cross-section of expected stock returns, even after controlling for well-documented asset pricing factors. These results are robust to the inclusion of industry portfolios in the set of test assets. They are also robust to the addition of firm characteristics and lagged instruments in the factor model. Bank credit growth is important because of its ability to predict business cycle variables as well as future labor income growth. These findings underscore the relevance of bank credit growth in stock pricing.