An early warning system for asset bubbles

New research from the McKinsey Global Institute shows that the right tools could have identified the recent global credit bubble years before the crisis broke.

As policy makers and business leaders gather in Davos, Switzerland, this week, much of their conversation will no doubt focus on how to drive a global economic recovery. Yet they should spend just as much time and energy discussing how to prevent the next devastating financial crisis—specifically, how to spot and prick asset bubbles as they are inflating.

For many years, some of the world’s most prominent central bankers said doing so was impossible.

However, new research from the McKinsey Global Institute (MGI) shows that rising leverage is a good proxy for an asset bubble—and that the right tools could have identified the recent global credit bubble years before the crisis broke. We urge policy makers to develop these tools and use them to ensure a more stable financial system, thereby avoiding more of the widespread pain and suffering caused by the current crisis.

Our new MGI report, Debt and deleveraging:

The global credit bubble and its economic consequences, details how debt rose rapidly after 2000 to very high levels in mature economies around the world.

But to spot a bubble, we need to know how much debt is too much. Some households, businesses, and governments can carry high levels very easily, while others struggle with lesser amounts.

The answer lies not in the level of debt alone but in the sustainability of debt. If borrowers cannot service their debt, they will go through a process of debt reduction, or deleveraging. We see today, for example, that many debt-burdened households are deleveraging—voluntarily and involuntarily—by saving more and paying down debt, or by defaulting.

To understand the sustainability of current debt levels, we looked at borrowing within individual sectors and subsectors of individual economies and at more granular factors such as the recent growth rate of leverage, borrowers’ ability to service the debt under normal conditions, and borrowers’ vulnerability to a disruption in income or a spike in interest rates.

Our analysis is far from perfect. The data we would ideally want are not wholly available. Still, the results show that borrowers in ten sectors within five mature economies have potentially unsustainable levels of debt, and therefore have a high likelihood of deleveraging.

Half of the ten are the household sectors of Spain, the United Kingdom, and the United States, and to a lesser extent Canada and South Korea—reflecting the boom in mortgage lending during recent housing bubbles.

Three are the commercial-real-estate sectors of Spain, the United Kingdom, and the United States—reflecting loans made during commercial property bubbles. The remaining two are portions of Spain’s corporate and financial sectors, both of which thrived during that country’s real-estate bubble, which is now deflating.

These findings confirm that the credit bubble was global in nature and fueled primarily by borrowing related to real estate.

More important, we see that this type of analysis could have identified the emerging bubble years ago, when its existence was still being debated. We performed the same exercise with data from 2006 and found that the household sectors of several countries (South Korea, Spain, the United Kingdom, and the United States) were already flashing red, as were the financial sectors in Switzerland, the United Kingdom, and the United States, along with a portion of Spain’s corporate sector.

If these tools had existed and had been made use of in 2006, they would have signaled the growth of credit bubbles in the red sectors almost two years before Lehman Brothers went bankrupt, credit markets seized up, and the global economy started contracting for the first time since the Great Depression.

And by pinpointing the sectors and countries, the data would have helped regulators identify the specific sources of the growing problem and address them in a targeted way. For example, they could have required tighter lending standards or bigger margin requirements in specific credit markets that appeared to be overheating.

Starting now, policy makers should develop a more robust international system to track the growth and sustainability of leverage in different sectors of the economy, beyond borders and over time. A key first step will be collecting better, more granular data. Today, the available figures are limited and not always comparable across countries.

If the data existed, we could distinguish between secured and unsecured household debt and between the debt of banks and nonbank financial institutions. Just as the Great Depression prompted the US government to revamp its outdated methods of measuring consumer prices, so should the current crisis motivate governments to develop more sophisticated ways to monitor leverage.

An international body—such as the Financial Stability Board or the International Monetary Fund—should work with national governments to collect and maintain the data. Central bankers and other policy makers entrusted with ensuring the overall safety and soundness of the financial system should use the data to identify systemic risks. They should then consider whether to use monetary policy or regulatory tools (either nationally or multinationally) to curb the buildup of dangerous pockets of leverage.

Such data would be valuable as well to business leaders. Bank executives, for example, could use them to guide lending strategies and refine risk models. And corporate executives could consider leverage trends when reevaluating marketing strategies and revenue projections.

The bursting of the great credit bubble is not yet over.

But governments around the world need to work together to prevent the next one, putting an end to the recent boom-and-bust cycle. With the right tools, policy makers can create a healthier financial system and lay the foundation for a stronger global economic recovery.