Identifying excessive credit growth and leverage

Lucia Alessi,Carsten Detken

doi:10.1016/j.jfs.2017.06.005

Lucia Alessi, Carsten Detken

Open Access

https://doi.org/10.1016/j.jfs.2017.06.005

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Abstract

Unsustainable credit developments lead to the build-up of systemic risks to financial stability. While this is an accepted truth, how to assess whether risks are getting out of hand remains a challenge. To identify excessive credit growth and aggregate leverage we propose an early warning system, which aims at predicting banking crises. In particular, we use a modern classification tree ensemble technique, the “Random Forest”, and include (global) credit as well as real estate variables as predictors.

Highlights

Past financial crises and in particular the global financial crisis have shown that excessive credit growth often leads to the build-up of systemic risks to financial stability, which may materialize in the form of systemic banking crises
To fully align the definition of banking crisis with the target of macroprudential tools like countercyclical capital buffers and leverage ratios, we extend it to include ‘near misses’, i.e. periods in which domestic developments related to the credit/financial cycle could well have caused a systemic banking crisis had it not been for policy action or an external event that dampened the credit cycle
A standard metrics for the evaluation of the performance of a classifier across a range of preferences is the Area Under the Receiver Operating Characteristic curve (AUROC), the ROC curve plotting the combinations of true positive rate (TPR) and false positive rate (FPR) attained by the model

Summary

Introduction

Past financial crises and in particular the global financial crisis have shown that excessive credit growth often leads to the build-up of systemic risks to financial stability, which may materialize in the form of systemic banking crises. As mitigating systemic financial stability risks is the objective of macroprudential policy, several macroprudential tools have been designed to curb excessive leverage and/or build-up buffers against likely future losses.. As mitigating systemic financial stability risks is the objective of macroprudential policy, several macroprudential tools have been designed to curb excessive leverage and/or build-up buffers against likely future losses.1 Such instruments include the countercyclical capital buffer, the systemic risk buffer as well as a potentially time-varying leverage ratio, and instruments directly targeting borrowers such as loan-to-value (LTV) and loan-to-income (LTI) caps.. Policymakers should supplement the signal coming from credit-to-GDP trend deviations with judgement based on a broader information set, as implicitly suggested in the current Capital Requirements Directive (CRD IV), which tasks the ESRB to provide recommendations on other variables which should inform the policy decision. Taking into account other conditioning variables is necessary because not all credit expansions are bad for financial stability, and the heroic task of identifying credit bubbles in real time requires assessing whether conjunctural credit developments might be disconnected from fundamentals or reflect excessive risk taking and overly optimistic expectations

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