Rising leverage is a good indicator of an emerging asset bubble. Writing in the Financial Times, Charles Roxburgh and Susan Lund urge policymakers to develop tools that could identify the next crisis years before it breaks.
As policymakers and business leaders gather in Davos 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 this was impossible. However, new research from the McKinsey Global Institute 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 policymakers 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 large amounts 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 assess 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, the borrowers' ability to service the debt under normal conditions, and the 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 10 sectors in five mature economies have potentially unsustainable levels of debt, and therefore have a high likelihood of deleveraging. Half of the 10 are the household sectors of Spain, the UK and the US, and to a lesser extent South Korea and Canada — reflecting the boom in mortgage lending during recent housing bubbles. Three are the commercial real estate sectors of Spain, the UK and the US — 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 fuelled primarily by borrowing related to real estate. More importantly, 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 (Spain, the UK, the US and South Korea) were then already flashing red, as were the financial sectors in the US, UK and Switzerland, and part of Spain's corporate sector.
If these tools had existed and been used in 2006, they would have signalled 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, policymakers 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 would distinguish between secured and unsecured household debt and between the debt of banks and non-bank 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 policymakers 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 build-up 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 should consider leverage trends when re-evaluating marketing strategies and revenue projections.
The bursting of the great credit bubble is not over yet. 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, policymakers can create a healthier financial system and lay the foundation for a stronger global economic recovery.
Charles Roxburgh is a London-based director of the McKinsey Global Institute and Susan Lund is its director of research, based in Washington, DC
This article originally appeared in the Financial Times.