A boom in credit usually foreshadows a financial crises but authorities failed to spot the build-up in total credit from the late 1990s through 2006 because they were looking the other way, according to an article in the latest quarterly review from the respected Bank of International Settlements (BIS).
While authorities were busy looking at lending by domestic banks, which only rose slowly, credit created by foreign institutions and non-banks – the so-called shadow banking sector that includes pension funds, mutual funds, hedge funds, and insurance companies – exploded.
“A new BIS database reveals, for example, that banks may provide as little as 30% of total credit to the private non-financial sector, as is currently the case in the United States,” said the article by senior BIS economist Mathias Drehmann.
The database, which captures all sources of credit regardless of source or origin, provides more information than the traditional measurements of bank credit and is therefore useful as an early warning indicator for financial crises, Drehmann finds.
That finding has very practical implications for banks as the Basel III global rules include countercyclical capital buffers that are based on a credit-to-GDP gap, but they don’t specify how national banking regulators should calculate that gap.
The article finds that the BIS database meets the Basel guidelines for measuring such a gap. Regulators can therefore use it to ask banks to set aside more funds as a buffer against possible losses when there are signs that the credit-to-GDP gap is exceeding critical thresholds.
Testing the validity of the measurements for total credit-to-GDP versus bank credit-to-GDP on the U.K., Drehmann found that the bank gap measure did not signal any large build-up in credit ahead of the global financial crises.
“In contrast, the total gap clearly captured the run-up in credit from the early 2000s onwards,” as it reflects the role played by non-bank funding, such as securitization, the main driver behind the explosion in credit.
The development of the database and the early warning indicator is part of the BIS’ focus in recent years on filling the gaps that were so glaringly exposed by the financial crises.
Not only were authorities looking in the wrong direction of credit generation, and mainly focused on keeping inflation under control, they didn’t have the right tools to spot the flashing red lights.
The latest BIS quarterly review makes further, practical progress in forging such new tools.
In addition to Drehmann’s article, which proposes how authorities can avoid being blindsided in the future, the review includes articles on how to spot systemically important institutions and how to tackle the failure of a too-big-to-fail financial institution.
The article by Chen Zhou of the Netherlands central bank and Nikola Tarashev of the BIS, looks to gauge the systemic importance of individual banks during financial crises.
Given the relative rare event of financial crises, the authors use tools from so-called extreme value theory with measurements of bank size and probability of default.
The authors find that the more systemically important banks tend to be larger, more leveraged and more active in interbank markets.
In contrast, the banks that are less systemically important tend to have a higher share of net interest income in total income, resort more to stable sources of funding and have lower operational costs.
A third article in the BIS review proposes a practical model for recapitalizing major banks that have failed or are at the brink of failure, an issue that was highlighted in Cyprus when authorities initially asked insured bank depositors to share some of the burden of rescuing the banking system.
Policy makers worldwide are currently working on how to make sure that the failure of a major bank, the so-called too-big-to-fail banks, doesn’t threaten to bring down entire economies, as occurred during the global financial crises in 2007-2009.
The article by Paul Melaschenko, and Noel Reynolds proposes a recapitalization mechanism for such too-big-to-fail banks that ensures that shareholders and uninsured private sector credits, rather than taxpayers bear the cost of resolution.
The mechanism is simple, respects the existing creditor hierarchy, can be applied to any part of a bank, and can be carried out during a weekend, the authors write.