Forecasting banking crises is difficult, but risks are on the rise in China, Hong Kong, Canada and Switzerland

In its quarterly report, the Bank for International Settlements (BIS) published a special article in which expansions were made to the list of early warning indicators of banking crises. High household debt and high international liabilities could create difficulties for countries and consequently lead to banking crises.

In an exploration of historical data, indicators that measure household and international debt have proved particularly effective in forecasting future banking crises, with the ratio of debt service to disposable income of households proving an especially useful indicator. In the years leading up to a banking crisis, the trajectories of these two indicators climbed relatively evenly and then dropped off noticeably once the banking crisis began. Combining debt variables with property price indicators raised the forecast quality even further. All in all, an analysis of the current global environment on this extended list of early warning indicators signals a potential accumulation of risks in some countries such as China, Hong Kong, Canada and Switzerland.

The study confirms much that might be intuitively expected. An increase in household debt could spark off banking crises some time in the future. At the same time, though, the authors explicitly caution against over-interpreting the results. One problem with using this data analysis to forecast banking crises is that such events are comparatively rare. In the analysis period there have only been 30 such crises. For investors in bank bonds, the study is unlikely to offer anything substantially new or concrete for them to factor into their investments. There will always be banking crises, with even macroprudential measures unable to prevent them. It is extremely difficult to forecast where and in particular when they are likely to occur. And forecasting the extent to which they would then impact individual banks is equally problematic. Ultimately the only possibility open to investors is to diversify their portfolios as far as possible and hope that the banking crises remain local and do not become global. Nevertheless, in view of the asymmetric profit distribution a conservative strategy for investors could be to sell off bonds issued by banks that are dependent on markets where the upper threshold readings of the BIS have been exceeded.

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