IMF Paper Analyzes Approaches to Guide Macro-Prudential Policy Setting

The paper on measuring credit gap highlights that assessing when credit is excessive is important to understand macro-financial vulnerabilities and guide macro-prudential policy. The Basel Credit Gap (BCG)—the deviation of the credit-to-GDP ratio from its long-term trend estimated with a one-sided Hodrick-Prescott (HP) filter—is the indicator preferred by the Basel Committee because of its good performance as an early warning of banking crises. However, for a number of European countries, this indicator implausibly suggests that credit should go back to its level at the peak of the boom after the credit cycle turns, resulting in large negative gaps that might delay the activation of macro-prudential policies. The paper presents two different approaches—a multivariate filter based on economic theory and a fundamentals-based panel regression.

Each approach has pros and cons, but they both provide a useful complement to the BCG in assessing macro-financial vulnerabilities in Europe. The authors show that both methodologies yield credit gaps that turn positive ahead of crises (similar to the BCG) but, unlike the BCG, do not remain negative for an extended period following the burst of a large and prolonged credit boom. The study does not test the crisis early warning properties of these two measures because, as experience with the BCG indicates, focus on these properties may produce a measure that performs poorly in other phases of the credit cycle. Having an indicator that can produce a view of the position of the economy over the entire financial cycle may inform recommendations of broader macroeconomic policy, beyond the decision on the CCyB.

Related Link: Working Paper

Keywords: International, Europe, Banking, CCyB, Macro-Prudential Policy, Basel Credit Gap, Research, Credit Risk, BCBS, IMF