Predicting Financial Crises: The Search for the Most Telling Red Flag in the Economy

Abstract

Canada is often cited as having worryingly high household debt-to-GDP and debt-to-disposable-income ratios, but the assets and net worth of Canadian households have grown more quickly than their debt. Using a new financial vulnerabilities barometer, we show that the inclusion of household debt servicing considerably improves the barometer’s ability to track financial vulnerability, particularly in advance of recessions. In contrast to the Bank of Canada’s financial vulnerability barometer, our index declines sharply after the Great Recession and indicates that financial risks are currently quite low. By focusing on debt servicing (the debt-service-to-disposable-income ratio) rather than debt, the barometer appears to yield fewer false positives than the Bank of Canada’s barometer. Further empirical analysis indicates that debt servicing is an improvement over traditional credit measures in predicting future economic growth and financial crises. We show that the relationship between debt servicing and both financial crises and economic growth is statistically significant. More specifically, we find that increases in new borrowing lead initially to a mild increase in economic activity and a significant reduction in the probability of financial crises, but they subsequently lead to a gradual increase in households’ debt service burden (the sum of principal and interest payments on their outstanding debts), expressed as a ratio of disposable income, which has a significantly negative impact on economic activity and a significantly positive impact on the probability of financial crises. Focusing on debt servicing provides a potential clue as to why we have not seen the type of market correction that has been repeatedly predicted for the Canadian housing market – namely, the fact that over the last 25 years the debt-service-to-disposable-income ratio has largely been flat, except for a mild recent increase, and (not coincidentally) an increase before the 2008 financial crisis. Our findings have policy implications for both the conduct of monetary policy and financial sector regulators. An immediate policy conclusion is that empirical models of financial system vulnerabilities should put more weight on the evolution of debt-service ratios and other indicators related to debt servicing. Furthermore, if financial stability is taken into consideration in the setting of monetary policy, central banks must be concerned with the trade-off between the short-run positive effects of increased borrowing on output and inflation and the potentially negative long-run effects that work their way through the debt-service channel. Lastly, regulators concerned with the housing market and overall financial stability should look beyond traditional credit-to-GDP measures, which were always going to increase in a low interest rate environment, and closely monitor the behaviour of debt servicing.