Financial Cycles:What are they and how to compute them?

IMF Area Department PresentationMarch 17, 2015

Benjamin HustonSanaa NadeemInci Otker-Robe

Financial cycles: detecting buildup in financial vulnerabilitiesWhat are financial cycles?• A multivariate measure that captures credit and property price

co-movement and periodicity– Average of credit, credit-to-GDP, and property price cycles (BIS

methodology).• Sept 2011 GFSR: credit growth combined with asset price growth tends to provide a

better measure of an impending financial crisis.

– Estimated using two econometric approaches:• Turning point algorithm • Frequency-based bandpass filter

Why are financial cycles important?• Peaks of a country’s financial cycle closely coincide with domestic

financial crises• Financial cycles can be used as a predictive indicator of impending crises• Credit aggregates and property prices tend to capture procyclicality in the

financial system

Financial cycle: elements

Example: United States (Drehmann et. al, 2012)

Key Point• Crises fall between medium-term peak/trough pairs• Recessions fall between short-term peak/trough pairs

Source: Drehmann et. al. (2012)

Financial cycle: frequency-based filter approach

Blue – financial cycle, i.e. average of medium term cycles in credit, credit/GDP and residential property prices (based on frequency-based filters)

Orange – peak in combined financial cycleGreen– troughs in combined financial cycleBlack – banking crisis

Source: Drehmann et. al. (2012)

Key Point• Cycles inflect downward prior to domestic crises

Computing financial cycles: data

• Three input series:– Real residential property prices– Real credit– Real credit/real GDP ratio

• Series should be in levels and standardized to a common point in time (e.g., 2010-Q3)

• Nominal series deflated using either GDP deflator or consumer inflation rates

• Recommended minimum sample size: 40 years of quarterly data

Computing financial cycles: techniques

Turning point analysis– Identifies local maxima and minima– Input series are real, normalized levels (as in prior slide)– Apply Quarterly Bry-Boschan (BBQ) algorithm (Harding, Pagen; 2002) to each

input series• parameters: min phase of 2 quarters; min cycle length of 40 quarters

– Use Harding and Pagen (2006) algorithm to combine input series’ peaks/troughs and get financial cycle

Frequency-based filter analysis– Identifies downward inflections in averaged cyclical components– Convert input series into 4-quarter log-differences– Apply asymmetric Christiano-Fitzgerald band pass filter (Christiano, Fitzgerald;

2003)• parameters: min/max periods of 8 and120 quarters; stationarity assumed• extract cyclical components from each input series

– take simple average of input series’ cyclical components to get financial cycle

Stylized facts

• Financial cycles have a lower frequency (10-20 vs. 6-8 years) and higher amplitude than traditional business cycles

• Recessions that coincide with financial cycle contractions tend to be deeper.

Source: Drehmann et. al. (2012)

United States

Guidance for Low Income Countries

IssueLack of long and relevant time series and frequent structural breaksmake computing financial cycles difficult

Recommendations• Compute Credit/GDP gap (template from Staff Guidance Note on

Macroprudential Policy; FSI-based tools (MCM Financial Toolbox)• Complement Credit/GDP gap (core indicator) with additional

measures (e.g. real credit growth, credit/GDP level and growth, structural private sector gap, debt service to income ratio, LTV ratio, signs of FX and funding mismatches, other market-based indicators) (Source: Staff Guidance Note: Table 1 in the main paper and Box 1 in the background paper for Low Income Countries)

• Examine credit and asset price co-movement over shorter time periods

• Always consider country specific circumstances

Credit/GDP gap as a financial cycle proxySouth Africa

Denmark

Financial Cycle Credit/GDP Gap Credit Cycle

Financial Cycle Credit/GDP Gap Credit Cycle

*Financial cycles and credit cycles computed using frequency-based filter approach; red lines mark onset of 2008 financial crisis; credit/GDP gap calculated using annual credit data that is temporally disaggregated to a quarterly frequency

Considerations for Low Income Countries• Is rapid credit growth a symptom of a buildup in financial stability

risks or financial deepening?

Source: Rapid Credit growth in Central and Eastern Europe: Endless Boom or Early Warning? Eds. Charles Enoch and Inci Ötker-Robe, Palgrave MacMillan (March 2007).

Considerations for Low Income Countries (Cont’d)

• Are house price increases the most accurate characterization of rising financial stability risks for LICs (vs. household indebtedness, household consumption, corporate leverage, government deficit, volatile capital flows, export concentration)

• Combine information from other potential contributors: e.g. tax policy, supply constraints, credit from nonbank sector

• Compare recent indicators with a relevant peer group if sample is too short

References• Borio, C. (2012). The financial cycle and macroeconomics: What have we

learnt? BIS Working Paper No. 395.• Christiano, L. and Fitzgerald T.J. (2003). The bandpass filter. International

Economic Review, 44(2):435- 65.Claessens, S., Kose, A. and Terrones, M. (2011) Financial Cycles: What? How? When? IMF Working Paper 11/76

• Drehmann, M, Borio, C., and Tsatsaronis, K. (2012). Characterizing the financial cycle: don’t lose sight of the medium term! BIS Working Paper No. 380.

• Harding, D. and Pagan A. (2002). Dissecting the Cycle: A Methodological Investigation. Journal of Monetary Economics 49 (2), 365–381

• ---. (2006). Synchronization of cycles, Journal of Econometrics, 132, 59-79.• IMF 2014. Staff Guidance Note on Macroprudential Policy.• ---. Staff Guidance Note on Macroprudential Policy. Detailed Guidance• ---. Staff Guidance Note on Macroprudential Policy Considerations for Low

Income Countries. IMF Policy Paper.