Turning to the supply side, the provision of liquidity is a key activity of the banking sector. Banks occur a nonnegligible credit risk, as the financial condition of companies may deteriorate by the time they utilize their credit facilities. Furthermore, the rate of utilization of credit facilities (which varies substantially over time) is not independent across time.3 Credit use tends to increase when money is tight, forcing banks to scramble for liquidity in order to meet demand. Banks themselves purchase insurance against unfavorable events. On the asset side, they hoard low-yielding securities such as Treasury notes and high-grade corporate securities. On the liability side, they issue long-term securities to avoid relying too much on short-term retail deposits. Within the banking sector, liquidity needs are managed through extensive interbank funds markets.

A corporate finance approach to asset pricing has several potential benefits. First, it enlarges the set of determinants of asset prices. In contrast to consumption-based asset pricing models, in which the net supply of financial assets is irrelevant for asset prices because they are determined exclusively by real variables, our model features a feedback effect from the supply of assets to the real allocations. The corporate sector is not a veil and the distribution of wealth within the corporate sector, and between the corporate sector and the consumer sector matters; in particular, the capital adequacy requirements imposed on banks, insurance companies and securities firms, and the current leverage of financial and nonfinancial institutions affect corporate demand for financial assets and thereby asset prices. Second, government influences the aggregate amount of liquidity through interventions such as open market operations, discounting, prudential rules and deposit insurance (see Stein 1996) and this impacts liquidity premia and asset prices. Consumption-based asset pricing models, provided they exhibit a form of Ricardian equivalence, have little to say about the impact of such policies.

Because the consumption-based asset pricing model is entirely driven by consumers’ intertemporal marginal rates of substitution (IMRS), it has several empirical limitations.4 First, it tends to underpredict both equity premia (see, e.g., Mehra-Prescott 1985) and Treasury bill discounts. Second, changes in marginal rates of substitution (discount rates) induce asset prices to covary. But as Shiller (1989, p. 346-8) notes, “prices of other speculative assets, such as bonds, land, or housing, do not show movements that correspond very much at all to movements in stock prices.”

Tags: , ,