The credit gap as a real-time early warning indicator of financial imbalances: a South African perspective (WP/26/04)

The credit gap as a real-time early warning indicator of financial imbalances Financial crises can result from excessive risk-taking during prolonged periods of growth when accompanied by weak regulation. Financial institutions tend to lend generously during economic booms and then restrict lending during downturns, which can worsen economic recessions. To address this, the Basel Committee on Banking Supervision suggests using the credit-to-GDP gap as an early warning indicator to identify rising credit risks and systemic instability. When this gap exceeds certain thresholds, the countercyclical capital buffer (CCyB) can be deployed to compel banks to hold larger capital buffers, thus strengthening the financial system against potential downturns. This paper explores different ways to identify the South African credit gap in real time. Using a constructed real-time data set, it evaluates a range of filtering techniques to isolate the credit gap from the credit-to-GDP ratio, and identify the real-time credit gap most consistent with the estimated ex post full sample credit gap. The one-sided Hodrick-Prescott filter produces a reliable real-time estimate of the credit-to-GDP gap, accurately predicting 75% of financial cycle turning points since 1980, and aligning well with full-sample estimates of the credit-to-GDP gap. It is therefore suitable to use as a guide for activating the CCyB.