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1 June 2016 CFA Institute Journal Review

Ending Over-Lending: Assessing Systemic Risk with Debt to Cash Flow (Digest Summary)

  1. Sonia Gandhi, CFA

The debt to cash flow (D/CF) measure provides a useful metric for assessing systemic risk and overall vulnerability of nations and their economic sectors. The authors find that the ratio is an important determinant of banking and debt crises but is less so for currency crises. D/CF also performs better than or on par with more conventional measures, such as public debt to GDP and credit to the GDP gap.

What’s Inside?

Although leverage is often linked to a nation’s vulnerability, the stock of total debt and the flow of gross savings have not been widely explored. The ratio of debt to cash flow (D/CF) is commonly used as a corporate finance measure with respect to individual firms and industries. The authors take it a few steps further to the level of nations and their economic sectors and examine its usefulness for understanding systemic risk. As an early-warning indicator, D/CF provides a useful additional measure of vulnerability to systemic banking and sovereign crises.

How Is This Research Useful to Practitioners?

Policymakers and regulators around the world seem to be grappling with frequent financial and sovereign crises. A strong case can be made for looking at alternative or additional measures that can serve as early-warning signals. The authors demonstrate the usefulness of D/CF and its variants for measuring financial risk and sovereign vulnerability. These measures can help supervisory institutions do a better job of gauging, assessing, and dampening imbalances in a financial system.

The authors demonstrate the efficacy of D/CF for measuring systemic risk and overall vulnerability of nations and their economic sectors. To accomplish this, the data for similar companies are aggregated to calculate the ratio for industry groups, and then the same is done for sectors and the nation as a whole. Because indebtedness and savings need not be evenly distributed between economic sectors, it is also important to consider the nation’s overall leverage.

A “one-size-fits-all” D/CF for nations is unlikely because countries with diversified economies, deep markets, and stable regimes may be able to carry a higher D/CF than countries with narrow, less developed markets and economies. Therefore, the authors provide a D/CF framework with four zones of escalating financial instability. The four-zone framework classifies economies as follows:

  • Inefficient zone: D/CF <5×; nation considered safe but underlevered
  • Stable zone: D/CF = 5–15×; appropriately levered nation
  • Warning zone: D/CF = 15–25×; overlevered nation exposed to a pattern of escalating instability
  • Crisis zone: D/CF = +25×; nation at significant risk of a financial crisis occurring or has experienced a recent financial or sovereign crisis

How Did the Authors Conduct This Research?

The authors illustrate the use of D/CF for firms and industry groups and then formulate time series of D/CF measures for economic sectors and 33 nations. They calculate D/CF as the ratio of a country’s stock of total debt to its flow of gross savings. For the nation as a whole, D/CF is total economy debt to national gross savings. Total economy debt is the sum of indebtedness in the household, corporate, banking, and government sectors. National gross savings is GDP less final consumption expenditure.

The authors perform quantitative tests of the signaling performance of D/CF with respect to financial crises. The signals of early-warning indicators are calibrated according to the policymaker’s preference regarding type I (missing a crisis) and type II (raising false alarm) errors, whereby the policymaker is assumed to be more concerned about missing a crisis than giving a false alarm. The authors show that D/CF performs better than or on par with more conventional measures, such as public debt to GDP, bank credit to GDP, and total credit to the GDP gap. The authors also document differences in the signaling performance of D/CF and its variants for banking, debt, and currency crises. The authors then classify nationwide D/CF levels, providing a four-zone framework for risk assessment. They depict the time series of nations within the four zones and qualitatively analyze the depicted patterns.

Abstractor’s Viewpoint

In a world where frequent financial crises and sovereign defaults seem to be the new normal, conventional ratios and metrics have proved inadequate as warning signals and indicators of systemic risk. Clearly, there is a need to expand the tools for assessing risk and look beyond the generally accepted metrics. The authors have explored a well-accepted measure used in corporate finance and extrapolated it to economic sectors and nations, providing an additional tool for risk warning and assessment. The four-zone framework offers a useful starting point for assessing the transmission of instability between sectors and from sectors to the nation. More research in this area would provide governments and regulators with a useful perspective and the knowledge to maintain balance and stability in the financial markets.

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