In a new Bank for International Settlements research report, “Evaluating early warning indicators of banking crises: Satisfying policy requirements,” the authors test the viability of new indicators to help policy makers find early warning signs in market deterioration. One of these, the Debt Service Ratio (DSR), works best in short-term policy time frames. This may become one of those acronyms that gets used in measuring the well-being of national economies.
The report, by Mathias Drehmann and Mikael Juselius of the BIS’s Monetary and Economic Department, is about many indicators and what might work best for tracking financial stability. The authors found that one measure, the credit to GDP gap, works best for longer-term evaluations. The Debt Service Ratio, or DSR, works best in the short term.
What is the DSR? According to the report, “The DSR is a measure of the proportion of interest payments and mandatory repayments of principals relative to income for the private non-financial sector as a whole and can be interpreted as capturing incipient liquidity constraints of private sector borrowers…. The DSR captures the burden that debt imposes on borrowers more accurately [than other indicators].”
This suggests to us that the DSR is a close relative of the Leverage Ratio and the Liquidity Coverage Ratio (LCR), and that on a macro basis the DSR tells a similar story.
The report continues: “The DSR’s early warning properties are especially strong in the last two years preceding crises. In the last four quarters before crises, the DSR is even a nearly perfect indicator.”
Meanwhile, the Leverage Ratio, defined as the Capital Measure divided by the Exposure Measure, is a similar idea. The Capital Measure is Tier 1 capital. The Exposure Measure gets messier but is still understandable, with the most recent full documentation available in the Consultative Document, “Revised Basel III leverage ratio framework and disclosure requirements.” Still, the idea is similar to the DSR as discussed in the authors’ report.
It is similar to the LCR as well, in that the LCR measures how much money does a borrower have to pay its liabilities in a given time frame. The DSR though attempts to be a more straight-forward indicator than LCR, with its various Levels and risk-weights for different assets. There is also no netting going on in the DSR that we know of. Our opinion is that the Leverage Ratio, once adjusted for GAAP and IFRS, is a lot easier to manage.
The importance of the DSR methodology, as we’ve commented on previously in different ways, is that risk capital measurements are important but the Leverage Ratio may be more important due to its simplicity. Although the definition of the Exposure Measure is a good example of over-complication, it is hands-down easier to get a handle on than RWA at each bank organization. We now have about a dozen examples of regulators, credit ratings agencies and even bank executives saying that their RWAs are not comparable to either other banks or even themselves over a given time horizon. Meanwhile, the Leverage Ratio is meant to be a blunter instrument and less subject to, well, subjectivity.
As a nearby cousin, the DSR is taking the same general idea, and the authors have found that for short-term policy analysis it works very well.