Staff Working Paper No. 738
By David Aikman, Jonathan Bridges, Stephen Burgess, Richard Galletly, Iren Levina, Cian O’Neill and Alexandra Varadi
We present a framework for measuring the evolution of risks to financial stability over the financial cycle, which we apply to the United Kingdom. We identify 29 indicators of financial stability risk, drawing from the literature on early warning indicators of banking crises. We normalise and aggregate these indicators to produce three composite measures, capturing: leverage in the private nonfinancial sector, including the level and growth of household and corporate debt, as well as the United Kingdom’s external debt; asset valuations in residential and commercial property markets, and in government and corporate bond and equity markets; and credit terms facing household and corporate borrowers. We assess these composite measures relative to their historical distributions. And we present preliminary evidence for how they influence downside risks to economic growth and different horizons. The measures provide an intuitive description of the evolution of the financial cycle of the past three decades. And they could lend themselves to simple communication, both with macroprudential policymakers and the wider public.