The Commercial Bank Leverage Factor in U.S. Asset Prices

Abstract

I present novel results on a commercial bank leverage factor that drives U.S. asset prices with important implications for both the time-series and the cross-section of returns. To motivate these findings, I modify the recovery rate of assets in a disaster model to include aggregate credit growth as an additional macroeconomic risk factor. It turns out there is a positive relationship between the postulated resilience of an asset and the stage of aggregate credit recovery. The intuition is behavioral in nature: credit expansions (contractions) breed investor overoptimism (pessimism), asset resilience increases (decreases) and the risk-premium decreases (increases). Additional implications in the cross-section are generated by the interaction of the credit cycle with the stock-specific recovery rate. The commercial bank leverage factor has a larger effect on small-, less profitable-, and value-stocks. A simple buy-and-hold strategy of the market index at short- and medium-horizons illustrates how investors can earn significantly higher excess returns and Sharpe ratios in recoveries and early stages of an expansion as opposed to credit booms.