Leverage may forecast the severity of the economic impact of a banking crisis

By James Langton |

A build up in private-sector leverage can amplify a systemic banking crisis, but it's not a good predictor of a forthcoming crisis, says Moody's Investors Service.

In a new report, the rating agency observes that while the connection between a rapid expansion in credit, and a decline in lending standards, "suggests that leverage could be a good indicator of banking system vulnerability, linkages between private-sector leverage and systemic crises in banking are far from strong or stable."

Moody's says its research suggests that private-sector leverage "does not appear to be a particularly powerful indicator of systemic banking crises, in terms of providing a strong signal about where and when crises will emerge."

It observes that many of the countries that recently suffered banking crises already had high leverage in the decade leading up to the start of the crisis in 2007, but did not experience a crisis until the global meltdown hit. Other countries had high leverage but no crisis, while others had crises despite relatively low leverage. And, some countries still have high leverage, but have not faced a banking crisis.

Yet, Moody's also finds that while leverage may not be a good leading indicator of systemic crises, "it could still indicate higher vulnerability to the impact of a banking crisis on the wider economy."

"In particular, leverage may be a conditional indicator — if there is a crisis, it might tell us something about how bad the economic impact of that crisis will be," it concludes.