Sustainable Financial Obligations and Crisis Cycles

Abstract

What level of indebtedness jeopardizes economic stability? We show that the ratio of financial obligations (interest payments and amortizations) to income is crucial for capturing debt sustainability. Estimating a regime-switching model on aggregate US data, we find that credit losses become highly sensitive to adverse shocks when household or business sector financial obligations ratios exceed threshold values of 10%. This occurs 1-2 years prior to each economic downturn in our sample, 1985Q1-2010Q2, indicating that excessive debt has a significant effect on the business cycle. Our results have implications for macroprudential policy and the design of countercyclical capital buffers for banks.

Keywords: Debt sustainability, credit losses, financial crises, leverage, financial obligations, regime-switching model, smooth transition regression

JEL Classification: E32, E44, G01, G21