Risky Business: Reading Credit Flows for Crisis Signals

IMF Blog, April 10, 2018

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Authors: Claudio Raddatz Kiefer
Date: April 10, 2018
Research coverage: 25 years of data for nonfinancial companies in 55 emerging and advanced economies.
Central question: How much of additional credit during booms flows to relatively riskier companies versus more creditworthy firms?

When credit grows rapidly, the firms where debt expands faster become increasingly risky relative to those with the slowest debt expansions.
An increase in the riskiness of credit allocation points to greater odds of a severe economic downturn or a banking crisis as many as three years into the future.
The buildup of lending to relatively less creditworthy companies adds an extra dose of risk on top of the dangers associated with rapid growth of credit overall.
Lending to risky firms can be rational and profitable, but may also reflect poorer screening of borrowers or excessive risk-taking.
Low interest rates can encourage a “search for yield,” leading banks and investors to extend credit to riskier companies that pay relatively higher rates of interest.
The riskiness of credit allocation may serve as a barometer of risk appetite.

Riskiness was elevated in the late 1990s.
Riskiness fell from 2000 to 2004, in the aftermath of financial crises in Asia and Russia and the dot-com equity bubble.
From a historic low in 2004, riskiness rose to a peak in 2008, when the global financial crisis erupted.
It then declined sharply before rising again to a level near its historical average at the end of 2016, the last available data point.
Riskiness may have continued to rise in 2017 as market volatility and interest rates remained very low in the global economy.

Supervisors should monitor both the total volume of credit and the riskiness of its allocation.
When warning signals flash, regulators can:
- require banks to hold more capital;
- impose limits on bank loan growth to restrain risk-bearing capacity and increase buffers;
- ensure the independence of bank supervisors;
- enforce lending standards;
- strengthen corporate governance by protecting minority shareholders.
A period of rapid credit growth is more likely to be followed by a severe economic downturn if more of that credit is flowing to riskier firms; policy makers should take appropriate steps in response.

Source: Risky Business: Reading Credit Flows for Crisis Signals (April 10, 2018).