Regulators Snub Sign That May Predict Next Crisis, BIS Says

Regulators may be overlooking a signal that could give them an opportunity to identify a new financial crisis, according to the Bank for International Settlements.

By focusing only on the gap between the size of an economy and the amount of bank credit within it, policy makers are ignoring contributions that foreign and non-bank lenders make to credit booms that typically precede systemic banking crises, according to Mathias Drehmann, a senior economist at the Basel-based institution. That role can be “significant,” as shown by a new BIS database that shows domestic banks currently supply only 30 percent of credit in the U.S. economy.

In the U.K., there was no bank-driven credit gap visible in the run-up to the most recent crisis because the securitization of assets was responsible for the surge in lending that took place, Drehmann said in an article published in the latest BIS Quarterly Review. Instead, the gap was apparent when lending from all sources was considered and may have acted as an indicator for regulators to push banks to build defenses, according to the paper.

Both measures “provide powerful early warning indicators for systemic banking crises,” according to the Review. “Gaps based on all sources of credit are likely to provide a more accurate indication of impending systemic crises.”

False Alarms

As well as capturing imminent crises better, the measure based on the gap between total credit and GDP doesn’t provide “significantly” more false alarms, according to the study.

The BIS looked at what the indicators were signaling within three years of the 33 crises since 1975 as a measure of their success or failure.

While both gauges gave some false alarms under the criteria by warning of crises that failed to materialize within three years, in many cases the emergency instead happened after four or five years, according to the paper. That would have justified regulators forcing banks to build buffers or taking other action to strengthen their balance sheets.

In other cases, while no crisis took place, there was sufficient stress in the system to justify regulatory action, according to Drehmann.

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