Using Economic Indicators as Proxies for Financial-System Leverage

Summary

The document considers whether historical indicators can provide a practical view of leverage in the financial system, given that leverage is difficult to measure consistently. The response suggests combining several types of data into an index: equity valuation relative to its long-run average, broad money and money multipliers, outstanding consumer and commercial loan categories, discretionary consumer spending, equipment leases, and business start-ups. The indicators aim to reflect different channels through which borrowing, credit availability, and financial activity may expand.

The answer presents these as possible proxies rather than a validated measure. It explicitly cautions that a composite index would likely have limited forecasting ability and might coincide with, or lag, economic conditions. The document offers no specific data sources, weighting scheme, historical test, or evidence that the proposed indicators reliably anticipate crises. The usefulness of any resulting measure would therefore depend on the chosen definition of leverage and on careful validation of each series.

Key ideas

• Financial-system leverage has multiple meanings, so a proxy should match the type of leverage being studied.
• Equity valuations, money aggregates, loan balances, spending, leases, and business formation may capture different credit channels.
• A researcher could combine selected indicators into a composite leverage index.
• The proposed indicators are possibilities, not a tested measure with established predictive power.
• A leverage index may be coincident with or lag economic developments.

Tags

# Measuring and proxies for leverage in the financial system


# Measuring and proxies for leverage in the financial system












It can be argued that the leverage - reflected by how much collateral people or firms need to put down to borrow and might lose if they fail to pay the loan back - used in the financial system is one of the quantities that proved to be fatal for the unfolding of the recent financial crises: http://www.bloomberg.com/news/2012-12-09/if-we-don-t-measure-leverage-we-risk-more-crises.html

The more surprising it is that this quantity doesn't seem to be systematically measured.

My question Are there any good proxies with some history available that could be used to get a grip on that quantity?

## Answer by Matt Wolf (score 3, accepted)

https://quant.stackexchange.com/a/8643

It depends obviously on which specific leverage you attempt to measure but you can certainly build some sort of index from, for example, the below:

- Aggregate smoothed equity P/E ratio divergence from long term mean (in a sense it reflects how money is levered to buy stocks at multiples of their long term P/E mean).

- Broad money in circulation -> Money multipliers

- Amount of outstanding prime/Alt-As/subprime loans outstanding , HELs, commercial mortgage loans

- Discretionary consumer spending

- commercial machine leases (not sure whether there is public information out on that)

- Amount of business startups

I think it may be interesting to gather data on those and to compile an index, though I would estimate that it will not have much predictive power and is rather coincident or even slightly lagging.

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