The credit-to-GDP gap is an indicator that measures how far the amount of credit in an economy has moved away from its long-run trend. It is calculated as the ratio of credit extended to the private non-financial sector to gross domestic product, minus an estimate of that ratio's trend. A large positive gap suggests that borrowing is growing faster than the economy can sustain, which has often preceded banking crises.
The measure was adopted by the Basel Committee on Banking Supervision in 2010 as the common reference point for setting the countercyclical capital buffer under Basel III. It is a tool of macroprudential policy rather than of monetary policy, and authorities are expected to use it as a guide alongside judgement and other indicators, not as a mechanical rule.
Formula and example
The gap at a given quarter is:
- is the stock of credit to households and non-financial companies from all sources, including banks, bond markets and foreign lenders.
- is nominal output over the latest four quarters.
- is the long-term trend of the ratio, in percentage points.
If private credit is 3,200 billion and annual GDP is 2,000 billion, the ratio is 160%. If the estimated trend is 152%, the gap is percentage points.
Under the Basel guidance the trend is estimated with a one-sided Hodrick-Prescott filter, a statistical smoothing method that uses only data available up to each date, with a very high smoothing parameter of 400,000. The high value reflects the view that credit cycles last much longer than ordinary business cycles.
Link to the countercyclical capital buffer
The Basel guidance maps the gap to a suggested buffer rate. When the gap is at or below 2 percentage points, the guide rate is zero. When it is at or above 10 percentage points, the guide rate reaches its maximum of 2.5% of risk-weighted assets. Between the two thresholds the rate rises in a straight line, so the 8-point gap in the example would point to a buffer of 1.875%.
National authorities publish the gap and the guide rate with each buffer decision but are free to depart from it. Many have done so. Some countries set a positive buffer in normal times regardless of the gap, on the grounds that capital should be available to release whenever a shock arrives. The buffer adds to the minimum Common Equity Tier 1 requirement and sits alongside the capital conservation buffer.
Evidence behind the indicator
Research by economists at the Bank for International Settlements found that, across many countries and several decades, the credit-to-GDP gap was the best single early warning indicator of banking crises among those tested, with useful signals appearing two to three years ahead. The reasoning is that rapid credit growth tends to go together with weaker lending standards, rising asset prices and higher leverage, all of which raise systemic risk. The gap rose sharply in several countries before the 2008 financial crisis. The BIS publishes quarterly gap estimates for a wide set of economies.
Limitations
The indicator has well-known weaknesses.
- Slow recovery after a boom. A long credit boom pulls the estimated trend upwards. After the bust, the gap can stay deeply negative for years, even when credit has started to grow strongly again.
- Sensitivity to GDP. In a sudden recession, GDP falls while the stock of credit does not, so the ratio and the gap rise just when capital should be released rather than raised.
- Financial deepening. In developing economies, rising credit may reflect healthy growth in access to finance, and a short data history makes the trend unreliable.
- End-point uncertainty. Trend estimates for recent quarters are revised as new data arrive.
Because of these problems, authorities supplement the gap with other measures such as credit growth rates, property prices, debt service ratios, lending standards and bank funding conditions. Within the European Union, the European Systemic Risk Board has recommended a set of indicators and allows national authorities to calculate additional gap measures suited to their own conditions.
The gap should be distinguished from the level of the credit-to-GDP ratio itself, which shows the depth of a financial system, and from the growth rate of credit. It is also separate from the output gap used in setting interest rates. Central banks watch all of these in assessing financial stability.