Aggregate debt servicing and the limit on private credit

Summary

Focus

Effective macroprudential policymaking requires identifying systemic risk in real time. Policymakers use various early warning indicators, with a core set related to private sector credit measures like the credit-to-GDP ratio. However, these credit-based indicators lack clear theoretical foundations and need statistical adjustments, which can reduce accuracy and practical applicability.

Contribution

We review the debt service ratio (DSR) as a theoretically grounded indicator of systemic risk. The DSR measures the aggregate debt-related expenses of borrowers relative to their income, providing a clearer economic foundation. Unlike the credit-to-GDP ratio, the DSR does not require detrending and offers accurate early warning signals. We review existing literature on the DSR, extend its historical measurement back to 1920 for 10 advanced economies and demonstrate its effectiveness in distinguishing between beneficial financial deepening and crisis risk over the past century.

Findings

The DSR has excellent early warning properties, rising before financial crises and declining afterwards. Historical data reveal that the DSR reached high levels during the Great Depression and after the 1980s, while remaining low during periods of financial repression. It outperforms early warning indicators based on the credit-to-GDP ratio and does not require detrending, even over long historical periods. The DSR's performance supports its use as a reliable measure of systemic risk. The DSR effectively delineates when credit expansions are beneficial compared with when they increase financial crisis risks. The DSR therefore acts as an upper limit on benign financial deepening.

Abstract

This paper reviews the debt service ratio (DSR) as a theoretically well-grounded indicator of systemic risk. The DSR has the desirable feature that it fluctuates around a stable level which makes its early warning signals easy to understand and communicate. In contrast, current early warning indicators (EWIs) based on credit-developments lack clear economic interpretations and require statistical detrending, which can reduce their accuracy and usefulness for macroprudential policymakers. The review of the literature shows that the DSR provides highly accurate early warning signals for crises and future economic slowdowns, outperforming traditional credit-based indicators. By extending the measurement of the DSR back to the 1920s – a novel contribution in this paper – we demonstrate its EWI effectiveness across different historical periods and show that the DSR acts as an upper limit on benign financial deepening. The paper also outlines questions for future research.

JEL classification: E32, E44, G01, N20

Keywords: macroprudential policy, early warning indicators, financial crises, debt service ratio, financial deepening, economic history