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Moody's: Private-sector leverage is not a reliable leading indicator of systemic bank crises.

Though an association between rapid credit expansion and a decline in lending standards suggests that leverage could be a good indicator of banking system vulnerability, linkages between private-sector leverage and systemic crises in banking are far from strong or stable, concludes Moody's Investors Service in a new report. Nevertheless, private-sector leverage may be loosely related to the depth of economic damage that can be wrought when such crises occur.

Researchers have tended to find only weak relationships between leverage (the ratio of private sector credit to nominal GDP) and banking system vulnerabilities, and more generally have struggled to find reliable forward looking systemic crisis indicators. This could be partly due to the fact that improvements in productivity can lead to increases in leverage, which should also respond to financial deepening -- the increased provision of financial services. Moody's analysis builds upon this research and also suggests that the relationship between aggregate leverage and systemic banking crises is not only far from simple, but may be unstable.

Moody's finds that private-sector leverage does not appear to be a particularly powerful indicator of systemic banking crises, in terms of providing a strong signal about where and when crises will emerge. Moody's notes that many countries that recently saw banking crises already had high leverage in the decade prior to 2007, but did not experience a crisis until that time. Moreover, some countries still have high leverage, but have not subsequently seen another banking crisis since 2009. Other countries had high leverage but saw no banking crises, while some countries experienced systemic banking crises despite relatively low leverage.

Moody's also highlights that while leverage may not be a robust forward looking indicator of such systemic crises, it could still indicate higher vulnerability to the impact of a banking crisis on the wider economy. In particular, leverage may be a conditional indicator -- if there is a crisis, it might tell us something about how bad the economic impact of that crisis will be.

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Publication:CPI Financial
Date:Oct 22, 2014
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