Financial regulators should be paying attention to households’ debt servicing capacity in assessing the buildup of financial risk, argues the C.D. Howe Institute.
In a new report, the Toronto-based think tank said that including household debt servicing (the debt service to disposable income ratio) in assessments of financial risks improves the ability to detect household financial stress, particularly ahead of recessions.
“By focusing on debt servicing rather than debt, the [report’s metric] appears to yield fewer false positives than the Bank of Canada’s barometer,” it said.
It also reported that, at this point, its measures of financial vulnerability indicate that risks remain low, despite the buildup in household debt.
“Focusing on debt servicing provides a potential clue as to why we have not seen the type of market correction that has been repeatedly predicted for the Canadian housing market,” the report said, noting that, “the debt-service-to-disposable-income ratio has largely been flat.”
The paper also argued that financial sector regulators and policymakers should be paying more attention to debt servicing metrics in their assessments of financial risks and setting monetary policy.
“If financial stability is taken into consideration in the setting of monetary policy, central banks must be concerned with the trade-off between the short-run positive effects of increased borrowing on output and inflation and the potentially negative long-run effects that work their way through the debt-service channel,” it said.