Early warning indicators
(Extract from page 28 of BIS Quarterly Review, March 2016)
The BIS has analysed and monitored early warning indicators of domestic banking distress. These indicators capture financial overheating and signal potential banking distress over medium-term horizons. They are calibrated with reference to the signal-to-noise ratio, defined roughly as the ratio of correctly predicted historical episodes to false alarms.
Table A reports three indicators, measured in most cases as of Q3 2015. The first is the gap between the credit-to-GDP ratio and its long-term trend (first column). The second is the gap between the residential property price index and its long-term trend (second column). The last one is the difference between the debt service ratio (DSR) and its average over time. It is estimated under two different assumptions (third and fourth columns): one under current interest rates, the second at rates that are 250 basis points higher. Importantly, this second estimate assumes an immediate and full (100%) pass-through of interest rate changes into DSRs. It does not take account of the fact that many debt contracts are based on fixed rates and will not reprice immediately. Nor does it reflect the ways in which borrowers and lenders would respond to interest rate movements by changing debt maturities, repaying their obligations or other measures. As such it overestimates the impact.
All three indicators suggest that the risk of banking strains remains elevated in a number of economies and regions. This is in particular the case for Canada, China and Turkey, where the credit-to-GDP gaps are above 10%. The same is true for a grouping of Asian economies (Hong Kong SAR, Indonesia, Malaysia, the Philippines, Singapore and Thailand). The indicator for Brazil, after having been persistently above this threshold for quite some time, at 9.9%, is just below this level.
In the past, two thirds of all readings above this threshold were followed by serious banking strains in the subsequent three years.
The DSR-based indicators also point to several of these economies. The size of the property price gap is closer to historical trends for most of the economies listed, although Germany and Japan stand out. When assessing these indicators, it is important to consider that they do not explicitly take into account any strengthening of regulation since the previous episodes of stress.
See "Highlights of global financing flows", BIS Quarterly Review, September 2015, pp 33-4. See M Drehmann, C Borio and K Tsatsaronis, "Anchoring countercyclical capital buffers: the role of credit aggregates", International Journal of Central Banking, vol 7, no 4, December 2011, pp 189-240.