Chicago Fed Letter: "Detecting early signs of financial instability"

Here is another possible tool for predicting financial stress. From Scott Brave, senior business economist, and R. Andrew Butters, graduate student, Kellogg School of Management, Northwestern University: Detecting early signs of financial instability. A few excerpts:

Following the financial crisis, policymakers and researchers have sought to identify new indicators that may be useful in gauging the relationship between the financial and nonfinancial sectors of the economy in the hope of detecting early signs of financial instability. The ratio of private credit to gross domestic product (GDP) has received a lot of attention in this regard.1 This leverage ratio serves as an early warning indicator of financial instability, insofar as it captures instances where the nonfinancial sector’s financial obligations form an outsized share of the broader economy’s resources.

In this Chicago Fed Letter, we propose an alternative early warning indicator to the private-credit-to-GDP ratio. Our measure is constructed as a subindex made up of two nonfinancial leverage measures used in the Chicago Fed’s National Financial Conditions Index (NFCI). We show that this subindex has performed well as a leading indicator for historical periods of financial stress and their accompanying recessions in the United States; we also demonstrate that it has been more accurate than the private-credit-to-GDP ratio in predicting both at longer forecast horizons.

Click on graph for larger image.

The solid black line is the nonfinancial leverage subindex of the Chicago Fed’s National Financial Conditions Index, and the solid blue line is the ratio of private credit to gross domestic product (GDP) detrended as explained in note 4. For ease of comparison, both measures have been scaled to have a mean of zero and a standard deviation of one over the period 1973–2012.

The horizontal (time) axis is measured in weeks. We assign the quarterly private-credit-to-GDP ratio to the last week of each quarter to be able to plot it on the same figure panel as the weekly nonfinancial leverage subindex. The shaded regions in panel A correspond with historical periods of financial stress based on the analysis in Brave and Butters (2012).

The dashed black line is the two-year-ahead prediction threshold for a financial crisis (panel A) ... calculated for the nonfinancial leverage subindex, as explained in the text.

And their conclusion:

Our nonfinancial leverage indicator signals both the onset and duration of financial crises and their accompanying recessions more reliably at longer lead times than the private-credit-to-GDP ratio.

Beginning with the November 15, 2012, NFCI release, we will include the nonfinancial leverage subindex in the publicly available materials for the NFCI at www.chicagofed.org/nfci.

This might be useful some time in the future. The Chicago Fed will include this as part of the NFCI release.