more credit with fewer crises 2011

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More Credit with Fewer Crises:

Responsibly Meeting the Worlds Growing Demand for Credit

A World Economic Forum Reportin collaboration with McKinsey & Company


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The information in this report, or upon which this report is based,has been obtained from sources the authors believe to be reliableand accurate. However, it has not been independently veried andno representation or warranty, expressed or implied, is made as tothe accuracy or completeness of any information contained in thisreport obtained from third parties. Readers are cautioned not toplace undue reliance on these statements. The World EconomicForum and its project advisers, McKinsey & Company, undertakeno obligation to publicly revise or update any statements, whetheras a result of new information, future events or otherwise, andthey shall in no event be liable for any loss or damage arising inconnection with the use of the information in this report.

The views expressed in this publication have been based onworkshops, interviews and research, and do not necessarilyreect those of the World Economic Forum.

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2010 World Economic Forum

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Contents

Preface 5

Working Group Members 7

Letter from the Working Group 9

Executive Summary 11

Introduction 19

Chapter 1: Feast and Famine: The Uneven Rise of Credit 21

Chapter 2: Criteria and Metrics for Sustainable Credit 31

Chapter 3: Making Sustainable Credit a Reality: Challenges Ahead 41

Chapter 4: Recommendations for Decision-Makers 51

Conclusion 59

Glossary 61

References 63

Technical Appendix

Acknowledgements

Project Team 81


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Almost a year ago, when world leaders met at the World Economic Forum Annual Meeting in January 2010, the global

economy was reeling from the worst nancial crisis in half a century a crisis attributed in large part to the failure ofthe nancial system to detect and constrain pockets of excessive credit. Those gathered in Davos were determinedto rethink, redesign and rebuild the institutions and practices that made the nancial crisis possible. Some of thediscussions also contained thoughts on recovery, highlighting previous pitfalls that needed to be addressed and the useand availability of credit was among those issues most actively explored.

In this spirit, the CEOs from many of the worlds leading nancial institutions, those committed to the Industry Partnershipprogramme of the World Economic Forum, endorsed a new initiative tasked with answering the following key questions:

What is a sustainable level o credit or the global fnancial system, a country or a given institution?

Where is credit most critical or economic development?

What actions can stakeholders take to ensure a healthy level o credit?

To answer these questions, a World Economic Forum team has worked with many of its constituents and the activesupport of McKinsey & Company for much of the past year to build a comprehensive global credit model, analyse therelevant literature and seek the counsel of over 50 business, political and academic leaders around the globe. The teamwas steered by a working group of senior industry executives actively guiding its work.

This report synthesizes the results of those efforts. Given its emphasis on the need for collaborative action to ensuresustainable credit, it is highly relevant to the theme of the World Economic Forum Annual Meeting 2011 Shared Normsfor the New Reality.

The report strikes an optimistic tone, showing how such collaboration can help ensure that the credit needed to underpinglobal economic development is provided safely and responsibly. It proposes a new set of metrics to provide earlywarnings of excess lending, complementing the Annual Meetings focus on building a global risk response mechanism.

Just as importantly, it also supports the Meetings focus on policies for inclusive growth, setting out mechanisms toaddress the credit blockages that hold back economic development currently some 90% of small enterprises indeveloping markets lack access to credit. Finally, the report spells out the actions that regulators, policy-makers, andnancial institutions can take to make sustainable credit a reality echoing the emphasis the Annual Meeting will place ongoing beyond analysis and elaborating innovative solutions to global challenges.

On behalf of the World Economic Forum, we wish to thank all who have contributed their time and expertise to thisreport, particularly the working group and the interview and workshop participants, Project Manager Isabella Reuttner,and our partners at McKinsey & Company. We all hope you nd the report to be insightful and a helpful reference for bestunderstanding the broad policy challenges associated with credit provision.

Kevin SteinbergChief Operating OfcerWorld Economic Forum USA

Gian Carlo BrunoDirector and Head of Financial ServicesIndustryWorld Economic Forum USA

Preace


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Working Group Members

Viral V. Acharya

Professor of FinanceLeonard N. Stern School of Business, New York University

Michael Bencsik

Head of Europe, Middle East & Global Businesses Group Strategy and Planning

HSBC

Andreas Beroutsos

Partner

Eton Park Capital Management

Fabrizio Campelli

Managing Director, Head of Group Planning and Strategy

Deutsche Bank

Jayan Dhru

Global Head of Financial Institutions

Standard & Poors

Michael Drexler

Managing Director, Global Head of Strategy, Commercial Investment Banking and Wealth Management

Barclays

Shawn MilesGroup Head of Global Public Policy

MasterCard

Dan Mobley

Global Head of Government Relations

Standard Chartered

Charles Roxburgh

Director

McKinsey Global Institute

Simon Samuels

European Banks Research

Barclays Capital

Alexander Wolfson

Managing Director and Head of Global Country Risk Management

Citigroup

From the World Economic Forum

Gian Carlo Bruno

Director and Head of the Financial Services IndustriesWorld Economic Forum USA


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Letter rom the Working Group

The nancial crisis has thrown a harsh spotlight on the use of credit. Pockets of credit grew rapidly to excess and

brought the entire nancial system to the brink of collapse. Yet, credit is the lifeblood of the economy, and much more of itwill be needed to sustain the recovery and enable the developing world to achieve its growth potential.

How, then, can the worlds growing demand for credit be met with greater stability and predictability and fewer crises?This report is our contribution to answering that question. It takes a detailed look at the uses of credit in the real economyto dene criteria for sustainable credit. And it presents a suite of tools that nancial institutions, regulators and policy-makers can use to gauge the sustainability of credit levels in both developed and developing economies.

We are condent that these tools will provide clear yet nuanced early warnings of potential credit bubbles and helpdecision-makers maintain credit within a dened band of sustainability, without unduly constraining growth. Just asimportant, the analysis and tools presented in this report highlight segments of the economy where credit shortages maystall growth. Indeed, a key aim of the report is to demonstrate credits role in the economic development cycle and helpcreate mechanisms to ensure access to credit where it is needed to support growth.

The report does not take a view on recent regulatory proposals, including from the Basel Committee on BankingSupervision (BCBS) and the Institute of International Finance (IIF), that may affect the supply of credit. Impact studies,most notably of Basel III, have already been concluded or are well underway elsewhere.

Rather, this work supports the ongoing discussion on how to achieve sustainable levels of credit through collaborationbetween nancial institutions (the engine of distribution), regulators (the keepers of stability) and policy-makers (thoseresponsible for economic growth). It also has specic relevance to each of these stakeholders.

For nancial institutions, the report provides insights on the potential demand for credit over the next decade and oncredit cycles over the past decade. And it provides guidance on what institutions can do today to ensure they meet creditdemand responsibly in the years ahead.

For regulators, the report proposes methodologies to monitor credit levels effectively, both within an economy andglobally. It provides rst thoughts on how to quantify credit contagion risk and offers a methodology to monitor this riskglobally.

For policy-makers, the report sets out approaches to identify credit segments at risk of overheating, as well as pockets ofthe economy that may be starved of credit. It proposes mechanisms to help address both problems.

This report will have succeeded if it stimulates thinking and spurs discussion on how credit levels can be kept sustainable.Ultimately, though, we hope the ndings and frameworks presented here will contribute both to increased stability for thenancial system and to sustained economic development across the world.


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Executive Summary

To support economic development, global credit levels must grow substantially over the next decade. At the same time,

public and private decision-makers must avoid a repeat of the credit excesses that recently brought the world nancialsystem to its knees. Can the worlds growing demand for credit be met responsibly, sustainably and with fewer crises?

The answer, this report shows, is yes. But to achieve this goal, nancial institutions, regulators, and policy-makers needmore robust indicators of unsustainable lending, contagion risk, and credit shortages and better mechanisms to ensurecredit drives development. The report is intended as a contribution to building that toolkit. It has four parts:

1. Feast and Famine: The Uneven Rise of Credit2. Criteria and Metrics for Sustainable Credit3. Making Sustainable Credit a Reality: Challenges Ahead4. Recommendations for Decision-Makers

1. Feast and Famine: The Uneven Rise o Credit

A detailed global credit model was developed to map historical credit volumes and forecast potential credit demand to2020 across the wholesale, retail and government credit segments in 79 countries, representing 99% of world creditvolume.

The precarious rise o credit, 2000-2009

Global credit stock doubled from US$ 57 trillion to US$ 109 trillion between 2000 and 2009, at a 7.5% compound annualgrowth rate. This expansion was spread fairly evenly between the government, wholesale and retail segments until 2009,when government lending rose sharply to fund the banking bailout and to support economic stimulus programmes(Exhibit i). By 2009, some 70% of the worlds US$ 150 trillion in nancial assets was being used to fund credit. That 70%was intermediated almost equally between capital markets and banks.

Developing markets credit stock grew the fastest by US$ 15 trillion between 2000 and 2009, an annual rate of 13%.The increasing depth of developing countries nancial systems during this period was a key contributing factor to thisgrowth.


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Credit growth over the decade was also fuelled by nancial innovation and industry practice, including:

The rapid growth of securitization in the US and United Kingdom until 2007 largely stalled since the crisis The rise of leveraged lending, including the private equity boom between 2005 and 2007 Rapid development of capital markets worldwide total nancing via government and wholesale corporate bonds

doubled to nearly US$ 49 trillion between 2000 and 2009 Low credit prices relative to risk as a result of competition among nancial institutions for growth

Between 2000 and 2009, the world economy grew at a healthy rate, and the worlds stock of credit outpaced GDPgrowth by less than 2 percentage points a year not an unsustainable rate of leverage increase. Beneath this aggregatepicture, though, there were pockets of overheating. Clear warning signs of credit excess in countries such as Ireland,Spain and Greece were largely ignored as borrowing continued to rise beyond sustainable levels. At the same time, othersegments were credit-starved, including Chinas retail segment, micronance in India, and the small business sectorworldwide. In developing markets, some 90% of small enterprises lack access to credit.

Potential credit demand to meet orecast economic growth to 2020

The study forecast the global stock of loans outstanding from 2010 to 2020, assuming a consensus projection of globaleconomic growth at 6.3% (nominal) per annum. Three scenarios of credit growth for 2009-2020 were modelled:

Global leverage decrease. Global credit stock would grow at 5.5% per annum, reaching US$ 196 trillion in 2020. Tomeet consensus economic growth under this scenario, equity would need to grow almost twice as fast as GDP.

Global leverage increase. Global credit stock would grow at 6.6% per annum, reaching US$ 220 trillion in 2020.Likely deleveraging in currently overheated segments militates against this scenario.

Flat global leverage. Global credit stock would grow at 6.3% per annum to 2020, tracking GDP growth and reachingUS$ 213 trillion in 2020 almost double the total in 2009 (Exhibit ii). This scenario, which assumes that modestdeleveraging in developed markets will be offset by credit growth in developing markets, provides the primary credit

growth forecast used in this report.



Rapid credit growth is forecast in developing markets, which will add almost US$ 50 trillion to their credit stock by 2020.

Chinas credit demand will lead global credit growth: it will require US$ 20 trillion more credit in 2020 than in 2009, with80% of that growth going to the wholesale segment. In developed markets, including the large Western economies,most of the growth will come from the government segment. In North America alone, the value of government bonds isexpected to grow by US$ 12 trillion to 2020. Deleveraging in overheated retail and wholesale segments of the developedworld will be signicant.

The nancing needs of infrastructure and green technology projects will form a signicant part of credit demand growth.

2. Criteria and Metrics or Sustainable Credit

After interviewing more than 50 industry CEOs, central bankers, regulators and academics, the study dened four criteriafor sustainable credit:

Limited hotspots, or areas of excess credit where repayment and servicing prospects are at risk Transparent and manageable contagion risk in order to reduce system volatil ity Limited coldspots, or segments where growth is inhibited by a lack of access to credit Alignment with social goals, to ensure that both economic and welfare needs are met

Based on these criteria, the study developed a suite of new tools to monitor credit levels.

Limited hotspots

The study analysed 15 credit crises over the past quarter century and derived a dashboard of 12 rules of thumb, orquantied upper bounds, to identify potential hotspots in wholesale, retail and government credit (Exhibit iii).

Transparent and manageable credit contagion risk

Credit contagion risk measures the likelihood and magnitude of the contagion that would arise from a hypotheticalfuture credit crisis in a particular segment. In addition to the rules of thumb above, which measure a credit segmentslocal sustainability, the study developed a framework to measure the connectivity between individual segments in differentcountries. There is potential to extend this methodology to create a global credit connectivity monitor covering mostcountries.



in hotspots

Limited coldspots

When a country falls into the lowest quintile of credit penetration among countries in a similar development stage, thismay be a rst indicator of possible coldspots. Additional indicators of coldspots include large unbanked populations andshallow capital markets, which can create structural barriers to meeting credit demand. The study developed a creditheatmap to monitor both hotspots and coldspots across countries and segments.

Alignment with social goals

In the long run, the scale and distribution of credit is only economically sustainable if it meets broader social objectives.Credit is linked to such objectives during all stages of a countrys economic development. In early stages, credit is usedto support family-owned businesses; next, it supports small and large corporations, and nally it is used to smoothconsumption. However, if credit is to drive consistent economic development, three basic foundations must be in place:strong laws and legal enforcement; creditable and functioning institutions; and macroeconomic and scal discipline.

3. Making Sustainable Credit a Reality: Challenges Ahead

Using the methodology set out above, the study addressed three key questions that will determine whether the worldsgrowing demand for credit can be met sustainably.

Are we at risk o uture crises and i so, where?

Even though some economies will deleverage over the coming decade, the analysis projects a signicant number of credithotspots across the world in 2020 including retail credit hotspots in countries representing almost half of global GDP.Government credit hotspots are projected for countries representing 13-14% of world GDP although Western Europe willbe more vulnerable. In wholesale credit, Asia and Western Europe will be the main drivers of hotspots in 2020 (Exhibit iv).



What is the uture risk o contagion?

The study mapped countries local credit sustainability against their degree of credit connectivity in 2009. Signicanteconomies including the United Kingdom, the US and Japan pose a potential threat in terms of local sustainability,credit connectivity risk or both (Exhibit v). In the US, high levels of absolute credit stock, combined with extensive links toother major credit segments, drive considerable contagion risk. Analysis of countries in the Eurozone shows that Ireland,Portugal and Greece pose the highest threat to the zones stability.

Chinas credit contagion risk appears relatively low, driven by low foreign credit and import penetration, along withrelatively low local sustainability risk. However, the second-order effects of a Chinese credit crisis, for example on supplychains, could be massive.



Will credit growth be sufcient to meet demand?

Rapid growth of both capital markets and bank lending will be required to meet the increased demand for credit and it isnot assured that either has the required capacity. There are four main challenges.

Low levels o fnancial development in countries with rapid credit demand growth. Future coldspots may result from thefact that the highest expected credit demand growth is among countries with relatively low levels of nancial access. Inmany of these countries, a high proportion of the population is unbanked, and capital markets are relatively undeveloped.

Challenges in meeting new demand or bank lending. By 2020, some US$ 28 trillion of new bank lending will berequired in Asia, excluding Japan (a 265% increase from 2009 lending volumes) nearly US$ 19 trillion of it in Chinaalone. The 27 EU countries will require US$ 13 trillion in new bank lending over this period, and the US close to US$10 trillion. Increased bank lending will grow banks balance sheets, and regulators are likely to impose additional capitalrequirements on both new and existing assets, creating an additional global capital requirement of around US$ 9 trillion(Exhibit vi). While large parts of this additional requirement can be satised by retained earnings, a signicant capital gap inthe system will remain, particularly in Europe.

The need to revitalize securitization markets. Without a revitalization of securitization markets in key markets, it is doubtful

that forecast credit growth is realizable. There is potential for securitization to recover: market participants surveyed byMcKinsey in 2009 expected the securitization market to return to around 50% of its pre-crisis volume within three years.But to rebuild investor condence, there will need to be increased price transparency, better data on collateral pools, andbetter quality ratings.

The importance o cross-border fnancing. Asian savers will continue to fund Western consumers and governments:China and Japan will have large net funding surpluses in 2020 (of US$ 8.5 trillion and US$ 5.7 trillion respectively), whilethe US and other Western countries will have signicant funding gaps. The implication is that nancial systems mustremain global for economies to obtain the required renancing; nancial protectionism would lock up liquidity and stiegrowth.



4. Recommendations or Decision-Makers

The study recommends eight actions that nancial institutions, regulators and policy-makers can take today to ensuresustainable credit levels for the future.

a. Integrate the concepts o sustainable credit into the regulatory agenda. New liquidity and funding regulationcan help reduce the frequency and intensity of credit hotspots and should be supported. However, decision-makersshould guard against the risk that such regulation limits sustainable global credit growth or creates new credit coldspots.

b. Create standardized government accounting practices to increase transparency and accurately assess

sovereign fnances. Governments should adopt uniform accounting standards so that a complete and transparentpicture of each countrys nancial resources and obligations is available. The challenge of creating and agreeing on suchstandards should be made part of the G20 agenda.

c. Encourage responsible borrowing through fnancial education. An international, government-led initiative shouldundertake an impact study of existing nancial education programmes worldwide, and then bring together governmentofcials, education leaders and nancial institutions to agree on an approach and implementation plan for improvingnancial literacy.

d. Encourage fnancing o local coldspots through targeted mechanisms. Governments and banks should createtargeted mechanisms to solve the well-documented problem of lending to SMEs in developing markets. In developedmarkets, they should establish a robust fact base on the extent to which SME lending is constrained, and developinnovative solutions to improve both the supply and the demand side.

e. Task a single agency with monitoring global credit levels and system-wide credit sustainability. A singleorganization should be tasked with monitoring global credit levels so that the risks to nancial institutions are accurately

assessed. This organization should build on the credit sustainability metrics presented in this report and combine themwith the Early Warning Exercise methodology developed by the FSB and IMF.

. Align banks risk appetite with sustainable credit criteria. Banks should ensure that their contribution to systemicrisk is considered at the level of day-to-day credit and lending decisions. Regulators and supervisory bodies shouldrecognize the contributions made to nancial stability by banks that are aligned with sustainable credit principles.

g. Drive innovation by fnancial institutions, developing new mechanisms that can saely meet uture

global credit needs. Governments could help kick-start securitization markets with targeted mechanisms such as agovernment-subsidized programme to securitize SME loans. Financial institutions should develop further mechanisms togrow balance sheet capacity safely and meet future worldwide credit needs including measures to strengthen housingand environmental nance, and to integrate the unbanked into the banking system.

h. Establish goals or efcient and deep capital markets by 2020 in developing economies. Governments,international agencies and the G20 should promote the strengthening of capital markets in developing countries byinstitutionalizing two fundamental capital market development goals: improving infrastructure to broaden participation byforeign rms and investors, and creating a sound institutional environment.


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Introduction

The rapid expansion of credit in recent decades has enabled unprecedented levels of economic development, business

activity, home ownership and public sector spending. Yet, excess lending in some markets and sectors sparked a globalcrisis which brought the entire nancial system to its knees. Not surprisingly, many commentators believe credit should bescaled back, even at the expense of economic growth.

The analysis in this report suggests the opposite is true. There are major pockets of the world economy, particularly indeveloping markets, whose growth has been held back by credit shortages, even over the past 10 years. To unlockdevelopment in these areas, and to meet consensus forecasts of world economic growth, credit levels must growsubstantially over the next decade. At the same time, public and private decision-makers must avoid a repeat of the creditexcesses that have caused so much damage in recent years.

Study Methodology

To create a robust fact base for the study, a detailed

global credit model was constructed to map creditvolumes between 2000 and 2009, and to project potentialcredit demand to 2020. The model spans 79 countriesrepresenting 99% of credit volume (with approximatedgures for the remaining countries). It disaggregateshistoric and projected lending by wholesale, retail andgovernment segments, dened as follows:

Retail credit: All household credit stock (loansoutstanding), including mortgages and other personalloans such as credit cards, auto loans and otherunsecured loans

Wholesale credit: All corporate and SME credit stock(loans and bonds outstanding)

Government credit: All public sector credit stock(including loans and bonds outstanding)

The model quanties both capital market bonds andlending from nancial institutions the latter aggregatedbottom-up from data at the sub-product level data,including on consumer nance, mortgages, leasing,and corporate and small and medium enterprise (SME)lending1. The model covers both commercial banks andnon-banking nancial institutions, includes credit held byboth residents and non-residents in a given country, andcalculates both non-securitized and securitized volumes.

In addition, the project team made up of nancialservices experts from the World Economic Forumand McKinsey & Company interviewed morethan 50 industry CEOs, rating agencies, centralbankers, regulators and academics. (They are listedin the Acknowledgements.) Based on these expertperspectives, criteria and tools to dene and trackthe sustainability of credit were developed as weremechanisms and incentives to make sustainable credit areality.

Finally, the research was underpinned by an extensivereview of the key academic and industry literature. (TheReferences section provides a full list of study sources.)

The report aims to build on this knowledge by providinga comprehensive, analytically robust fact base on

historic and potential future credit growth, by bringing apractitioners perspective to bear on the complex problemof dening and measuring sustainable credit, and bysetting out actionable recommendations.

Can the worlds growing demand for credit be metresponsibly, sustainably and with fewer crises?

The answer, this report shows, is yes. But to achieve this

goal, nancial institutions, regulators and policy-makersneed a far more robust toolkit to foresee and forestallpotential credit crises. They need earlier, more in-depthindicators of unsustainable lending, contagion risk andcredit shortages and better mechanisms to ensure thatcredit drives development.

The report, based on a nine-month collaboration betweensenior practitioners and experts, is intended as acontribution to building that toolkit. (See sidebar, StudyMethodology.) It maps the potential growth in creditdemand; proposes criteria to dene and tools to track thesustainability of future credit growth; applies those toolsto identify the segments most at risk of credit excess or

shortage over the coming decade; and sets out actions toachieve a healthy balance of credit in the world economy.

The report has four chapters:

Chapter 1: Feast and Famine: The Uneven Riseo Credit, shows how the steady expansion of creditover the past decade masked pockets of excess andshortage. It then forecasts the credit required to meeteconomic growth projections over the coming decade.

Chapter 2: Criteria and Metrics or SustainableCredit, proposes a set of criteria by which sustainablecredit can be dened and managed, and introduces

a range of tools and methodologies to provide earlyindicators of areas of credit excess, contagion orshortage.

Chapter 3: Making Sustainable Credit a Reality:Challenges Ahead, applies these tools to identifysegments at risk of excess credit, which couldpotentially lead to a crisis, as well as those in whichcredit shortages could stunt growth.

Chapter 4: Recommendations or Decision-Makers, sets out principles for action and potentialmeasures that nancial institutions, regulators andpolicy-makers can take to ensure sustainable credit for

the future.The Technical Appendix provides further detail on thestudys methodology, fact base and data output.

1 Credit gures only include transactions involving the end-user, i.e. the nal customer; credit such as interbank lending is excluded to avoid double counting.


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Credit grew rapidly in every major region of the world. However, developing markets credit stock grew the fastest byUS$ 15 trillion between 2000 and 2009, an annual rate of 13% (Exhibit 3). The increasing depth of developing countriesnancial systems during this period was a key contributing factor to this growth, as was their greater openness to foreigndirect investment (FDI). For example, the tenfold increase in Indias FDI between 2000 and 2008 was matched by agrowth in credit stock from US$ 10 billion to US$ 50 billion. And the dramatic increase in Brazils credit bureau coverage,from less than one in 10 adults in 2005 to the majority of the population just four years later, coincided with a near-triplingof credit stock to almost US$ 60 billion in 2010.



Financial innovation and industry practice uel credit growth

Credit growth was also fuelled by nancial innovation and industry practice. Consider the rapid adoption osecuritization, the repackaging and sell-on of loans by banks to other investors. In the US, for example, the growthin securitization volumes outstripped that of retail credit between 2005 and 2007; in 2007, total securitization volumeshad reached US$ 9 trillion, equivalent to almost two-thirds of the countrys total retail credit stock. Securitization wasalso a signicant contributor to mortgage and consumer nance volume growth in the United Kingdom, growing vefoldfrom US$ 0.1 trillion in 2000 to US$ 0.5 trillion in 2006. The sub-prime crisis led to a sharp decline in new securitizationissuances in the US and United Kingdom by between 35% and 90%4 from 2007 to 2008, depending on segment,denitions and data sources. Government- and agency-backed securitization in the US is the only segment that hasshown signs of recovery to date.

Likewise, leveraged lending played a key role in wholesale credit growth. Lower interest rates, loosened lendingstandards, and increased use of the structure and distribute model by investment banks all led to a private equity boombetween 2005 and 2007, when some of the largest leveraged buyouts (LBOs) in history took place. In 2007, leveragedlending levels reached approximately 7% of total wholesale credit volumes in both the US and the United Kingdom.However, the nancial crisis brought the LBO market to a standstill: by 2009, leveraged lending had shrunk to less than0.2% of total wholesale lending in these markets.

A further important contributor to credit growth was the rapid development o capital markets. Total nancing viacapital markets including both government and wholesale corporate bonds doubled to nearly US$ 49 trillion between2000 and 2009. Growth was particularly steep in the developing world, with the capital markets of Asia, the Middle East,Eastern Europe and South America all expanding at an annual rate above 12% for the decade. The Chinese wholesalebond market alone grew at 49% per annum from 2000 to 2007.

A fourth contributor to credit growth was competition among nancial institutions for growth, causing banks to expandtheir balance sheets signicantly. In some segments, the race for growth led to low credit prices relative to risk. In large

corporate lending, this underpricing was largely rational lending at a loss led to protable cross-selling of specializednance, risk management products, investment banking, and the like. In sectors such as commercial real estate, however,lending was under-priced relative to the risks of these assets, as is now painfully clear in many commercial real estatemarkets (such as Ireland). And in the retail segment, it proved unsustainable and led to signicant losses. In particular, thethin margins in mortgage lending left no buffer for default when US house prices began to plummet at the end of 2006.

These nancial industry innovations and practices should be seen alongside governments signifcant role in drivingrapid credit growth in the wholesale and retail segments. For example, the tax deductibility of interest payments in theUS and elsewhere encouraged increased mortgage lending and led companies to favour debt over equity5. Moreover,the bank bailouts of recent years were a major, if unanticipated, contributor to the increase in governments ownindebtedness.

Credit growth compared with GDP growthOn the face of it, the growth of credit between 2000 and 2009 might appear to have been unsustainable. But the risein credit must be seen against the backdrop of economic growth. Between 2000 and 2009, the world economy wasgrowing at a healthy rate at 5.3% annually in nominal terms, or 2.2% in real terms. The rate of GDP growth between2000 and 2008 was 6.2% nominal and 2.8% real. This means that the worlds stock of credit outpaced GDP growth byless than 2 percentage points a year not a wide margin. In theory, there is nothing unsustainable about this picture: aslong as credit grows broadly in line with economic growth, the credit is put to good use and borrowers can meet interestobligations and repay principal.

At the global level, then, there was only a modest increase in leverage (the ratio of credit to GDP) between 2000 and2009. However, the picture differed markedly for developing and developed economies. Even though the developingworlds credit stock grew fastest6, its GDP grew at an astonishing 11.3% annually from 2000 to 2009; its leverage

4 Different data sources use different approaches to dene and quantify securitization. Even the broadest and most conservative measure, however, shows a largedrop.5 International Monetary Fund. Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy. Prepared by the Fiscal Affairs Department. Approved by CarloCottarelli, 12 June 20096 Developing world dened as all countries and regions except North America, Western Europe and Japan.



therefore rose by only 1.8% a year over the decade. On the other hand, the developed economies in the Organisation of

Economic Co-operation and Development (OECD) saw their annual GDP growth fall from 4.3% in 1990-2000 to 3.4%in 2000-2009. Their credit levels rose much faster: while OECD leverage grew at just 1.2% a year in 1990-2000, it grewalmost three times faster, at 3.2% a year, over the following decade (Exhibit 4).

Segments o credit excess and shortage

For the world in aggregate, this analysis indicates that overall growth in credit volumes and leverage was notunsustainable. Why, then, did things go so horribly wrong? As the sharp increase in developed world leverage suggests,the aggregate picture masked pockets of overheating. The methodology developed in this study, and set out in the nextchapter, shows that there were clear warning signs of credit excess as early as 2006 in now crisis-struck countries suchas Ireland, Spain and Greece signs that were largely ignored as borrowing continued to rise beyond sustainable levels.

For example, retail credit volume as a proportion of Irelands GDP doubled from 43% to 87% between 2000 and 2006 a drastic rate of increase which should have agged a problem. Instead, retail credit continued to rise, reaching 99% ofGDP by 2008. Likewise, Spains wholesale credit volumes, driven by property development, doubled from 52% to 110%of GDP between 2000 and 2006 clearly an unsustainable rate of growth. Again, warning signs of the impending crisis

were missed, and wholesale credit volumes rose to 134% of GDP in 2008.

There is controversy about the exact levels of Greek government debt over the past decade. According to OxfordEconomics, Greeces government borrowing stood at 88% of GDP in 2000 and rose to over 140% in 2006. Eurostat putsthe gures at 115% in 2000 and 108% in 2006. Either set of gures would have provided a clear early warning of thecountrys sovereign debt crisis in 2010.

While some credit segments were overheating, however, others were credit-starved. Consider Chinas lack of accessto retail credit, which contributes to the countrys relatively low consumption7. Chinas outstanding consumer creditas a proportion of GDP, at less than 15%, is the lowest of any of the 10 largest economies; the same is true of itsconsumption, at 35% of GDP8. It is notable that over 70% of the 4 trillion renminbi government stimulus packagelaunched by Chinas government in 2008 was directed towards infrastructure spending, while less than 10% went insupport of consumption.

7 While there is a view that Chinas low credit penetration is driven to a large extent by cultural factors, analysis shows that Chinas investment-led model hasskewed the economy towards industry and has made corporate investment too cheap. Inefcient investment into excess capacity has occurred at the cost ofChinese consumption. See McKinsey Global Institute, If youve got it, spend it: Unleashing the Chinese consumer, August 2009.8 Calculated using data from Global Insight



Despite the recent turmoil around Indias micronance industry9, small-scale lending in that country is a clear example of a

credit-starved segment. Annual credit demand by the poor in India is estimated at US$ 15 billion, yet the current volumeof micronance barely tops US$ 1 billion; only about 5% of Indias rural poor have access to nance10. The micronancesector lacks the infrastructure needed to ensure that credit is provided safely with credible repayment and servicingprospects. As recent events show, the political environment also creates barriers to micronance meeting its full potential.

Worldwide, small business is a key sector that lacks sufcient access to nance, with the gap in credit for micro, verysmall, small, and medium enterprises (MSMEs) estimated at between US$ 3.1 trillion and US$ 3.8 trillion11. Theseenterprises make a major contribution to innovation, long-term economic growth, income stability, and employment indeveloped as well as developing countries. In Japan, for example, 99.8% of corporates are SMEs, which between themaccount for 70% of employment. In recent years, SMEs share of economic activity in OECD countries has increasedrelative to large companies. However, SMEs access to capital markets is restricted by informational barriers, transactioncosts, and a perception of higher risk12. In developing markets, some 90% of MSMEs lack access to credit, despite theinnovative small business credit models in place in many countries.

Potential Credit Demand to Meet Forecast Economic Growth to 2020

The analysis of the past decade of credit growth suggests that decision-makers should be concerned with detectingpockets of excess credit growth rather than constraining overall credit expansion. Indeed, the challenge of providingsufcient credit to segments with unmet demand warrants just as much attention as the need to avoid areas of excess.

A segment-level forecast of potential future credit demand provides analytical underpinning for both these tasks. Thestudy therefore built a regression model to forecast the global stock of loans outstanding from 2009 to 2020 brokendown by country as well as by retail, wholesale, and government segments assuming the consensus forecast of aglobal economic recovery is correct. (See Sidebar, A Model to Forecast Potential Credit Demand.)

9 See, for example, Discredited, The Economist, 4 November 2010 http://www.economist.com/node/17420202?story_id=17420202&CFID=154289182&CFTOKEN=9040896010 Basu, Priya and Pradeep, Srivastava. Scaling up Mircronance for Indias Rural Poor. World Bank Policy Research Working Paper 3646, June 200511 Goland, Schiff, and Stein, Two trillion and counting: Assessing the credit gap for micro, small and medium-size enterprises in the developing world, IFC-McKinsey & Company report, October 2010. MSMEs include formal and informal micro, very small, small and medium enterprises with less than 250 employees.This denition is broader than the one used by other reports, such as the CGAP report.12 Seoul G20 Business Summit, How can the small and medium enterprise sector be nurtured? November 201013 The consensus GDP growth projection adopted for this analysis is Global Insights widely accepted forecast: nominal growth of 6.3% per annum between2009 and 2020, equivalent to real GDP growth of 3.3% per annum over this period. Global Insights forecast is built on an aggregation of country-level forecasts.14 The studys forecast of potential demand therefore does not include new supply limitations that may enter the market, such as Basel III, or more expensive andlimited securitization markets.

A Model to Forecast Potential Credit Demand

The model developed in this study calculates potential credit demand the total level of demand for credit by countryand segment, assuming that there is no restriction on supply over and above the restrictions in place prior to 2010. Forthe purposes of the model, credit stock is dened as the total outstanding lending amount in US dollars at year end.This includes both capital markets (bonds outstanding) and traditional loans.

The following assumptions underpin the models projections: Consensus projections are met for global economic growth that is, nominal growth of 6.3% per annum in 2009-

2020 13

Macroeconomic indicators such as consumption, exports and GDP growth have the same effect on future creditsupply and demand as they did in the past decade14

A xed US dollar exchange rate based on 2009 actual is used for all historic and projected credit stock Interbank lending is excluded from all credit stock data to avoid double counting Nominal credit stock values in all cases, in US dollars No further major crises or large-scale currency debasing take place over the decade

It is important to note that the model projects the annual growth of total global nancial wealth (that is, credit and equitycombined) to be almost one percentage point higher than GDP growth. Wealth has outstripped GDP for much of thepast 15 years, and given the rapid growth of credit, equity and savings in developing markets, this trend is likely tocontinue in the decade ahead.



Three scenarios o uture credit growth

Three scenarios of credit growth for 2009-2020 were modelled using this methodology (Exhibit 5):

1. Global leverage decrease. This scenario assumes there will be modest global deleveraging, predominantly due toreduction in credit over a few years in overheated credit segments of developed markets, offset in part by continuedcredit growth in developing markets15. Under this scenario, overall global credit stock will grow at 5.5% per annum (0.8percentage points below consensus GDP growth), reaching US$ 196 trillion in 2020 (Exhibit 6). Equity would need togrow almost twice as fast as GDP, bringing the ratio of credit to equity back down to its 2000 levels.

15 See McKinsey Global Institute, Debt and deleveraging: The global credit bubble and its economic consequences, January 2010



2. Global leverage increase. This scenario is based on the pure output of the credit demand model; in other words,

it assumes the full potential demand for credit will be met. This is plausible if one expects rapid credit growth indeveloping markets, political pressure on banks to increase lending, and a trend to de-equitize by large companies.However, the likelihood of deleveraging in currently overheated segments militates against a global increase inleverage. Under this scenario, the worlds credit stock would grow at 6.6% per annum (0.3 percentage points fasterthan GDP) to reach US$ 220 trillion in 2020 (Exhibit 7). The ratio of credit to equity would reach 3.0 by 2020.

3. Flat global leverage. This scenario, which provides the primary credit growth forecast used in this report, assumesthat global credit stock will grow at 6.3% per annum to 2020, tracking GDP growth. In this outlook, modestdeleveraging in developed markets will be offset by credit growth in developing markets. Under this scenario, theworlds credit stock will reach US$ 213 trillion in 2020 almost double the total in 2009 (Exhibit 8). The increaseddemand for credit would be split between capital markets (expected to make up US$ 39 trillion of the additionaldemand) and bank lending (US$ 66 trillion). The ratio of credit to equity is projected at 2.7 in 2020.


28/84



It is worth noting that the nancing needs of infrastructure and green technology projects will form a signicant part ofcredit demand growth. (See sidebar, Financing Infrastructure and Green Technology.)

Financing Inrastructure and Green Technology

Financing for infrastructure and green technology projects will contribute signicantly to overall credit demand. Thecumulative increase in global infrastructure spending between 2009 and 2020 is estimated at US$ 27 trillion to US$ 33trillion18, funds that will be required to:

Upgrade aging infrastructure in developed countries Meet the demands of urbanization and increase living standards in developing countries Build transportation infrastructure to facilitate growing international trade Achieve sustainable development goals

Although not all of this increased spending will require credit nancing, it amounts to between 26% and 31% of thetotal credit demand increase to 2020 as projected by this study. Credit demand for infrastructure nancing from boththe public and private sector is likely to be substantial.

18 Seoul G20 Business Summit, Closing the gap in infrastructure and natural resource funding, November 2010



Chapter 2: Criteria and Metrics or Sustainable Credit

The experience of the past decade shows that, even when overall credit growth is at economically sustainable levels,

country- and segment-level pockets can swing quickly into excess. At the same time, it is possible for key segmentsto remain credit-starved even in a world of credit abundance. Financial institutions, regulators and policy-makers are insearch of approaches to help credit ow to the places it is needed to support economic growth and to ensure thatunsustainable credit booms are spotted and tamed before they spiral out of control.

As a contribution to that quest, this chapter proposes a set of criteria to dene sustainable credit in which excesslending is avoided, contagion risk is transparent, and sufcient credit ows to the areas where it is needed to supportgrowth and welfare.

The chapter then introduces a suite of metrics to track credit sustainability at the segment level, raise early warnings ofimpending crises, and provide a fact base for interventions. These metrics include indicators to help identify both credit-ooded hotspots and credit-starved coldspots; and a framework rooted in network theory to measure the creditconnectivity of different segments and countries, allowing for more accurate monitoring of contagion risk.

Sustainable Credit: A Challenge o Defnition

This study recognized it would be no easy task to come up with a denition of sustainable credit that was both specicenough to be meaningful and broadly accepted by public and private decision-makers. Before attempting a denition,therefore, the study canvassed the question What is a sustainable level of credit? in interviews with more than 50industry CEOs, rating agency executives, central bankers, regulators and academics.

Although there was a breadth of perspectives among these experts, there was also signicant convergence. In particular,while a minority of interviewees believed current absolute levels of borrowing were unsustainable and would requiresubstantial deleveraging, the general view was that the current global credit stock is at sustainable levels but shouldbe rebalanced towards economically benecial uses. In this view, the recent nancial crisis was driven by ineffective

monitoring and managing of information asymmetries, which drove misallocation of credit and excess contagion risk.

Diering perspectives

On some questions there was real debate. Some interviewees believed that the market mechanism was the most efcientlong-term means of credit allocation. For example, Ivan Pictet, Founder and Managing Director of Pictet & Cie, arguedthat:

Government regulation is not the answer and will continue to distort markets as regulation lags market movement andwill dampen growth and sustainability.

Others, however, argued that effective interventions in the market were needed. Neil Thomson, a Partner at private equityinvestment group Apax Partners, contended that:

While free markets work in theory, often asymmetric information and misalignment of incentives create distortions thatneed to be addressed. We see this frequently in credit markets.

There was also disagreement on which types of credit use should be prioritized in any attempt to dene and promotesustainable credit: some emphasized the importance of large infrastructure projects such as mobile networks and powerplants in driving development, while others believed increased lending to underserved market segments such as SMEsand low-income populations was key.

There was substantial agreement, however, that transparency of information ows (for example, on borrower risk proles),combined with the strength and capabilities of institutions (for example, at pricing risk), were crucial for a balancedallocation of credit. Many interviewees emphasized that if credit supply to underserved segments is to be increased, itwill be important to address lenders perceived lack of prot opportunity, as well as barriers to entry such as supply chain

complexity or lack of information on borrowers.



The experts interviewed provided several other valuable perspectives on what would make for sustainable credit. One

was on how the contagion effects of credit could be reduced. Several people emphasized the centrality of improvingthe capacity of institutions (including regulators and rating agencies) to assess contagion risk including the risk ofexceptional 1 in 20 events. This was seen as particularly important, given that rational individual behaviour can becollectively foolish: in the recent crisis, rms were often decreasing their own risk but increasing total system exposure19.

Objectives or sustainable creditThe perspectives thus canvassed led the study to dene a set of basic, overarching objectives for sustainable credit. Firstand foremost, credit should enable earlier investment and consumption than would otherwise have been achievable. Indoing so, it should support growth of the economy overall, or of earnings. Implicit in this denition is the assumptionthat future income growth will allow repayment; that there is condence between the counterparties; and that the credittransaction enables both the creditor and the debtor to make a return, be it an economic return or welfare.

Beyond these basic requirements, sustainable credit should also meet several mutually reinforcing economic and socialobjectives, including:

An acceptable level of condence in repayment of the credit, both its interest and principal (that is, lending withacceptable risk criteria)

Credit-driven volatility and risk transfer should be set at an acceptable level; there should be transparency on wheresuch risk transfer occurs; and the frequency and amplitude of credit-related crises should be kept at acceptably lowlevels

Credit allocation should be focused towards societies priorities, including delivering on economic development goals Not permitting major shifting of credit burdens across generations

Within these broad parameters, though, sustainable credit levels will differ signicantly between countries and sectors,depending on a wide range of factors including their economic development proles and the depth of their nancialsystems. The expert discussions emphasized, therefore, that the question of sustainable credit needs to be considerednot just at the global level but also at a country or regional level and for each major sector within those countries in

particular, retail, wholesale and government borrowing. As Denis Bugrov, Chief Strategy Ofcer at Sberbank, pointed out:

It is difcult to generalize sustainability at a global level when disparities are different across markets and the economicenvironment is key to lending.

Moreover, interviewees pointed out that the denition of sustainable credit may vary over the course of the business cycle.

Clear Criteria and Robust Tools or Sustainable Credit

Consideration of these perspectives led the study to dene four criteria for sustainable credit:

1. Limited hotspots, or areas of excess credit where repayment and servicing prospects are at risk2. Transparent and manageable contagion risk in order to reduce system volatility3. Limited coldspots, or segments where growth is inhibited by a lack of access to credit4. Alignment with social goals, to ensure that both economic and welfare needs are met

Based on these criteria for sustainable credit, this study proposes a suite of new tools to measure and monitor creditlevels, including:

A scorecard of indicators, or rules of thumb, to measure retail, government and wholesale credit and identify credithotspots

A framework rooted in network theory with metrics to track credit connectivity risk Heatmaps to track credit hotspots and indicate coldspots by segment and country

These tools complement the Early Warning Exercise methodology developed by the Financial Stability Board (FSB)and the International Monetary Fund (IMF). (See sidebar, In-depth Credit Metrics that Complement the Early WarningExercise.)

19 Prior to the recent crisis, many nancial institutions had comparable risk exposures, based on similar funding structures, risk-management practices, andmitigation strategies. This led nancial institutions to believe that their institutionally held risk was acceptable, while in actual fact systemic risk was building. Whenhousing prices collapsed and subsequently the nancial assets linked to mortgages, all nancial institutions looked to close similar positions in a, at that time, veryilliquid market, ultimately leading to extreme losses.



In-Depth Credit Metrics that Complement the Early Warning Exercise

One of the G20s rst reactions to the nancial crisis in November 2008 was to task the FSB and IMF to conductan early warning exercise (EWE) to identify potential risks within the nancial system, with the results to be sharedcondentially with the International Monetary and Financial Committee annually. Recently, the IMF published a responseto this request, with a detailed methodology to identify different types of risk20.

This study endorses the EWE approach of developing metrics to help ag potential concerns in the economy. The EWEmethodology assesses many different types of risk, including overall nancial market volatility, asset bubbles and stockvaluation. The metrics and tools presented in this report, however, focus solely and in detail on credit risk, looking atstock and ow measures as well as their derivatives (average annual change). This reports in-depth global perspectiveon credit is complementary to the EWE, providing institutions and policy-makers with credit insights to inform theiractions.

The remainder of this chapter shows what each of the four sustainable credit criteria mean in practice, and proles thetools proposed to measure and monitor credit against those criteria.

1. Limited hotspots

For every country and credit segment (for example, US retail mortgages), an upper bound denes hotspot levels abovewhich there is a material chance of a credit-related crisis. These hotspots can be caused by an over-exuberance of eitherdemand or supply, or the interplay of both.

Two factors determine these upper bounds:

Credible principal repayment prospects. The upper bound in this case is the maximum credit burden above which

the credibility of principal repayment diminishes rapidly. It is measured in two ways: through current leverage ratios,and through the rate of change of leverage ratios.

Credible servicing prospects. The upper bound in this case is driven by income prospects to service interestpayments and repayment of principal. It is measured through the annual repayment burden (interest and principal) both the current credit repayment burden and the rate of change of the repayment burden.

To determine warning indicators for hotspots, the study looked at the history of credit crises over the past 50 years, andquantitatively analysed 15 credit crises in detail, ranging from the 1985 Korean crisis to the recent government debt crisesof 2009 (Exhibit 12). These crises were selected on the basis of three criteria: their scale was signicant; they were rootedin unsustainable credit within the wholesale, retail or government segment (rather than in a general macroeconomicimbalance); and sufcient data was available. For each crisis, historic sustainability indicators were calculated (in line withthe above denition of sustainable credit), both for the year of the crisis and for the eight years leading up to it. From these

results, quantitative rules of thumb were derived for a range of dened sustainability indicators21

.

20 International Monetary Fund, The IMF-FSB Early Warning Exercise: Design and Methodological Toolkit, September 201021 This study acknowledges the caution that has been expressed about such upper bounds: Alan Greenspan, for example, has argued that rule of thumb limitson credit, where the regulator hopes to anticipate a credit crisis, may be ill-advised. (The Crisis, Alan Greenspan, April 15, 2010. Paper written for the BrookingsInstitution.) However, it is submitted that the approach set out here to dene and use rules of thumb is sufciently nuanced to prevent its crude application.



Tools and Metrics: Rules O Thumb to Identiy Credit Hotspots

This study has developed 12 rules of thumb22 to identify potential credit hotspots, covering wholesale and retail creditas well as government debt (Exhibit 13). These indicators examine both the stock and ow measures of credit (in orderto measure both debt repayment and servicing prospects). They also examine the forward-looking derivatives of thesetwo metrics (the forecasted average yearly change over the next ve years); the static indicator as well as the derivativeare critical for detecting possible pockets of unsustainable credit growth. Together, the rules of thumb can be used as acomprehensive dashboard of early warning indictors of potential credit hotspots.

Stock measures, which are often leverage ratios retail, wholesale or government liabilities as a percentage of GDP, arethe more commonly used indicators of indebtedness. Yet, ow and rate-of-change measures are just as important indetecting unsustainable credit patterns.

22 One of the rules of thumb outstanding government credit exceeding 90% of GDP has been proposed by Reinhart and Rogoff to denote the point at whichgovernment debt becomes a brake on economic growth.



As an example, consider the ow measure proposed here for retail credit. The rule of thumb is that a hotspot may beforming when the interest burden plus the average principal repayment on retail credit exceeds 20% of GDP. In Ireland,for instance, the interest burden plus average principal payment on retail credit was already at 21% of GDP in 2006,an early indicator of the potential unsustainability of its mortgage bubble; it reached to 25% in 2008 as the countryapproached crisis.

The rate-of-change measures track the growth of both stock and ow. In the wholesale segment, for example, onerule of thumb is that credit growth is potentially unsustainable if wholesale credit as a proportion of GDP is projectedto grow faster than 2 percentage points a year over the next ve years. Likewise, wholesale interest payments plusaverage principal payment as a proportion of GDP could be unsustainable if they are forecast to grow faster than2 percentage points a year over the next ve years. In Spain in 2006, for instance, the projected ve-year growthfor wholesale credit as a proportion of GDP was 6 percentage points a year, an early indicator of the potentialunsustainability of its commercial property development boom.

Indeed, applying these rules of thumb to the growth of credit in key segments over the past decade shows that theseindicators would have sounded early warnings about unsustainable credit growth in several countries that have recentlyfaced credit crises (Exhibit 14). These warnings could have prompted more rigorous analysis of these hotspots, using abroader set of metrics.

Finally, it should be emphasized that these rules of thumb should be applied as early warning indicator thresholds;levels of credit in excess of the thresholds should trigger more detailed review. It is not appropriate to apply an absolutelimit for credit sustainability, given the diversity in countries economic proles.

2. Transparent and manageable credit contagion risk

Beyond ensuring the economic sustainability of individual credit segments in other words, local sustainability thedomino effects of credit crises must be understood and managed to ensure sustainability at the global level.

There have been a range of attempts to dene and assess contagion, typically focusing on implications for the realeconomy23. Having reviewed this literature, the study focuses on the connectivity between individual credit segments andcountries. Credit contagion risk, as dened here, measures the likelihood and magnitude of the contagion that wouldarise from a hypothetical future credit crisis in a particular segment in a given country.

23 See, for example, Kaminsky, Reinhart, and Vegh, The unholy trinity of nancial contagion,October 2003; IIF, Systemic Risk and Systemically Important Firms, May 2010; and Andrew Haldane, Rethinking the Financial Network, April 2009



To quantify the potential contagion risk of each credit segment in a particular country, two metrics are therefore required:

A measure of the local credit sustainability of individual segments within countries; the rules of thumb described abovefull this role

A measure of the connectivity between individual segments in different countries; the approach for doing this is set outbelow

To measure the connectivity between segments, this study proposes a credit connectivity ramework based on theve principles of network design:

i. Transparency and monitoring. Credit segments are assessed based on the extent and type of their linkages withother countries and credit segments, and on the extent to which this network map is communicated with marketplayers and the public. Regulatory quality is a useful approximation for transparency and monitoring24.

ii. Interconnection and modularity a measure of the number and size of a segments connections to other creditsegments. Interconnection in credit markets can be approximated by trade measures that spread credit crises directly.Import penetration is the best measure of connection, which transmits shocks from the originating crisis directly ontoexporting countries.

iii. Fault tolerance. This measure tests the extent to which a credit segment relies on external funding sources; theability to isolate a single credit segment; and the availability of alternative credit sources in the event of weakness. Forexample, foreign capitals share of a segments nancial system that is, its capital markets and bank lending volumes shows the extent to which isolating that segment would be difcult.

iv. Dimensioning and scalability the ability to increase the size of the credit segment without increasing risk, byscaling up local funding or credit supply, or by ensuring that excess funding lines (current and future) are aboverequired levels. This measure is approximated via the credit segments absolute size.

v. Intervention the extent of local or regional support and strength of contingency plans that is in place in case ofcredit segment weakness. This can depend, for example, on regulatory quality.

Together with the rules of thumb set out above, which gauge the local sustainability of a given credit segment, this creditconnectivity framework will allow decision-makers to quantify that segments level of contagion risk to other segments andcountries. The results of such an exercise are set out in the next chapter. In this studys view, the risk of contagion fromone segment or country to another should be considered acceptable only if:

The economic benet arising from the connectivity between the two segments (for example, through tradeagreements) outweighs the contagions likely effect on the impacted segments local credit sustainability, and

In the event of weakness in any segments local credit sustainability, that segment can be isolated sufciently well tominimize the economic cost of contagion to other segments and countries

This approach is supported by previous work that has sought to understand connectivity and contagion risk in elds

outside of nancial services including sheries, forest res, and immunology. (See sidebar, Insights on Contagion fromOther Disciplines.)

The credit connectivity framework proposed here can be used to assess a particular countrys overall level of connectivityto the global nancial system, but also to map the country-to-country credit connectivity of individual nations in otherwords, the extent to which any one country would be exposed to a credit crisis in any other country.

There is potential to extend this model at a more granular level to create a global credit connectivity monitor covering awide range of countries. The monitor would measure the connectivity of each countrys credit segments with segments inall or most other countries. The monitor would thus identify areas of concern and ag economic and credit concentrationrisks, allowing policy-makers to make informed trade-offs as to acceptable levels of contagion risk.

The indicators used to calculate credit connectivity are set out in greater detail in the Technical Appendix.

24 Regulatory quality captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promoteprivate sector development. See Kaufmann, Daniel, Kraay, Aart and Mastruzzi, Massimo, The Worldwide Governance Indicators: Methodology and AnalyticalIssues (September 2010). World Bank Policy Research Working Paper No. 5430.



Insights on Contagion rom Other Disciplines

In addition to the use made ofnetwork theory in this report to illustrate and measure contagion risk, manyapproaches from other disciplines have been suggested to understand and mitigate the threat of contagion in thenancial services industry25.

Fisheries: The example of Chilean salmon has been used to emphasize the importance of diversity to avoid similarvulnerabilities. These salmon were subjected to similar treatments to avoid diseases. As a result they all developed thesame vulnerabilities and were wiped out in large numbers by a single virus in 2008. This example underlines the valueof contrarian approaches promoting diverse regulation to avoid symmetric vulnerability in the nancial sector.

Forest fres: The use of controlled res to rejuvenate forests demonstrates that res that wipe out parts of a forestcan actually be a positive property of an ecosystem, as long as they are controlled and do not spread beyond the area

that needs rejuvenation. This example is quoted as a rationale for introducing independent resolution frameworks forsystemically important nancial institutions (living wills) to allow bankruptcies of unhealthy banks without impactingthe system.

Immunology: The human body uses white blood cells as part of a pre-emptive system to avoid sickness to seek anddestroy dangerous pathogens before they can spread. This example illustrates the opportunity for nancial institutionsto establish a pre-emptive system to screen for threats and raise warning signals early.

3. Limited coldspots

Coldspots are segments where growth is inhibited by a lack of access to credit. Coldspots could be caused by marketinefciencies such as underdeveloped nancial markets, a lack of transparency and weak institutions. Conversely,there is evidence that the existence of adequate credit supply increases GDP growth through a range of transmission

mechanisms, including increased entrepreneurship and increased access to schooling26. Brown University economicsprofessor Ross Levine, interviewed for this study, emphasized that:

Credit supply and nancial development can increase economic growth by adding liquidity and diversication to themarket and by generating a return from credit owing to the best investment.

Experts assert that there are structural coldspots in developing countries based on structural lack of access to creditand a wider lack of nancial development27. As the next chapter shows, potential credit demand will grow sharply overthe coming decade in many countries with relatively low levels of nancial development, pointing to the possibility thatsuch coldspots could be a signicant problem in the years ahead. One marker of a countrys nancial development is theproportion of the population with bank accounts; in many of the fastest growing credit markets, very large numbers ofpeople remain unbanked, creating a serious structural barrier to meeting credit demand.

Additionally, a lack of sophistication in capital markets coldspots can results in coldspots. Denis Burgov of Sberbank citedRussia as an example:

A general lack of understanding of risk leads to a binary view of good versus bad credit risk, so pricing and lending canbe too strict.

Inter-country comparisons provide a further clue to the existence of credit coldspots. Where a country falls in the lowestquintile of credit penetration among countries in a similar development stage, this may be a rst indicator of possiblecoldspots.

25 See Rethinking Risk Management in Financial Services Practices from other domains, World Economic Forum, April 201026 World Bank Policy Research Working Paper, Asli Demirguc-Kunt and Ross Levine: Finance, Financial Sector Policies and Long-Run Growth, 200827 International Monetary Fund Working Paper, Enrique Gelbard and Sergio Leite: Measuring Financial Development in Sub-Saharan Africa, 1999



Tools and Metrics: Heatmaps to Track Credit Hotspots and Coldspots by Segment

This study proposes a credit heatmap to monitor both hotspots and coldspots across countries and segments.Hotspots are those segments that fall above the rule of thumb on any of the four criteria, while coldspots are identiedby grouping the countries according to their development stage and looking towards the lowest quintile of credit stock.Additional metrics to help dene coldspots include the size of the unbanked population and the size and depth ofcapital markets; these are discussed in the next chapter. Exhibit 15 shows an example of such a heatmap for 2006.The next chapter discusses how credit heatmaps can be used in todays context.



Exhibit 16 : Credit stock levels during economic development

1 High growth = Real GDP CAGR > 4.5% from 2000-2009, Medium growth = Real GDP CAGR > 3% from 2000-2009, Low growth = Real GDP CAGR < 3% from 2000-2009

GDP per capita,USD 000

Leverage, total credit / GDP, Percent

Turkey

Brazil PolandLithuania

HungaryLatviaCroatia

Estonia

Slovakia Taiwan

Singapore

France BelgiumCanada

AustriaSwedenUS

FinlandNetherlands

AustraliaDenmark

Pakistan

Kenya

Vietnam

India

Nigeria Philippines

Egypt UkraineIndonesia

Spain

ItalyUKJapanGermany

ChinaPeru

Bosnia

Colombia

Bulgaria South AfricaArgentinaRomania Malaysia

MexicoRussia

Belarus

Thailand

Korea

Tunisia

Czech Portugal

IsraelGreece

Hong Kong

New Zealand

Ireland

Luxembourg

Morocco

Macedonia

46

27

29

28

23

43

34 31

41

28

33

46

21

35

38

27

40

30

30

34

34

32

22

32

46

Low growth countries 1

High growth countries1

Medium growth countries 1

Retail

Wholesale

Government

Percent of total credit

penetration by segmentCredit penetration by segment and in groups of countries with

similar overall penetration level, Credit / GDP, Percent 2009

40 80 120 160 200 240 280 320

Switzerland

0

20

40

60

80

100

120

0

Norway

100% =

55

97

182

219

247

100% =

100% =

100% = 145

100% =

100% =

100% = 100% = 298

4. Alignment with social goals

In the long run, the scale and distribution of credit is only economically sustainable if it also meets societys broader socialobjectives. Credit is linked to social objectives during all stages of a countrys economic development. In early stages ofdevelopment, credit is used to support family-owned businesses; next, it supports small and large corporations; and nally itis used to smooth consumption. Muhammad Yunus, founder of Grameen Bank, goes so far as to say that credit is a humanright, and adds:

If we are looking for one single action which will enable the poor to overcome their poverty, I would focus on credit.28

To illustrate how smart allocation of credit can drive economic development goals, consider the example of theWirtschatswunder(economic miracle) of post-war West Germany. Some US$ 1.6 billion of credit issued underthe European Recovery Plan was steered towards export-focused industries such as iron and steel, and to essentialinfrastructure such as energy and transportation. As growth picked up, credit was steadily deployed to new sectors such asmanufacturing, as well as to housing. Strong institutions and policies such as high depreciation allowances and other taxconcessions for investment underpinned West Germanys rapid economic growth during this period.

This studys analysis shows that the credit mix and the level of leverage in any given country are correlated strongly with itslevel of economic development (Exhibit 16). Countries at an early stage of development are characterized by very low levelsof leverage and a credit mix skewed towards the retail sector. As GDP rises, so leverage levels rise too, and wholesale creditplays a much greater role as industry expands. Wealthy countries with sophisticated nancial systems see much higher

28 Yunus, Muhammad. Keynote address delivered at the 85th Rotary International Convention held in Taipei, Taiwan, 12 June 1994



levels of leverage, and substantial credit penetration in all segments retail, wholesale and government. However, once

leverage exceeds 250% of GDP, the correlation with development begins to fall away and government accounts for the lionsshare of lending.

Policies, incentives and mechanisms to direct credit to meet social goals should be carefully designed to minimizeeconomic distortions and avoid unintended consequences. For example, regulatory mechanisms intended to make thesystem safer may have the unintended consequences of forced subsidiarization, trapping liquidity and limiting tradenance ultimately lowering output and slowing economic growth.

Finally, it should be emphasized that, if credit is to drive consistent economic development, a set of basic legal,institutional and policy foundations must be in place. Without this underpinning, there is every likelihood that credit will besquandered on economically and socially unproductive uses. There are three fundamental requirements:

Strong laws and legal enorcement. Contracts should have a creditable legal backing to support the belief of

repayment; the bankruptcy resolution process for failed ventures should be orderly, efcient and predictable; and asystem of property rights should be in place to ensure credit is backed by collateral, assets are protected and thereis a system of ownership. The growth stories of Brazil and Chile in recent decades illustrate the value of a strong legalstructure: both countries beneted from stable legal and tax frameworks for long-term investment projects.

Creditable and unctioning institutions. The economy should have relatively sophisticated private nancialinstitutions and banks; an independent central bank should be able to make decisions on currency and interestrates without constraint of political pressure; and institutions and organizations should suffer from minimal fraud andcorruption. Perus stunted economic development during the 1980s and 1990s illustrates the high cost of weakinstitutions and endemic corruption: an estimated 15% of gross income was paid out in bribes29.

Macroeconomic and fscal discipline. Government should support a healthy macroeconomic environment; and

government should save money when revenues are growing. Numerous crises in recent history demonstrate theimportance of this tenet.

29 Peruvian economist Hernando de Soto points to lack of institutions and laws that protect property and create capital as a factor limiting economic growthand the under penetration of capital. Additionally, the scarcity of creditable institutions causes a drag on the productive economy, as in Peru where widespreadcorruption caused a large extra-legal manufacturing sector.



Chapter 3: Making Sustainable Credit a Reality: Challenges Ahead

How, then, does one apply the sustainable credit criteria and tools discussed above? This chapter uses the methodology

set out in this report to highlight the major challenges that stand in the way of achieving sustainable, productive creditgrowth in the decade ahead. In particular, it addresses three key questions that will determine whether the worldsgrowing demand for credit can be met sustainably:

Are we at risk of future crises and if so, where? What is the future risk of contagion? Will credit growth be sufcient to meet demand?

Are We at Risk o Future Crises And i so, Where?

To answer this question, the study applied the rules of thumb set out in the previous chapter to projected credit demandover the coming decade. The answer is unequivocal: even though some economies will deleverage over this period, theanalysis reveals a potential new set of credit hotspots. The heatmap tool introduced in Chapter 2, when applied acrossnations and segments for 2009, highlights a range of countries in which there are potential credit hotspots (Exhibit 17).



Credit hotspots on the horizon

This study projects a signicant number of credit hotspots across the world in 2020 whether the scenario modelled isone of increased, decreased or at global leverage (Exhibit 18). A country is identied as potential hotspot if it violates anyone of the four rules of thumb for the segment, as described in Chapter 2.

The sustainability of retail credit could be a global problem in 2020: in countries representing almost half of global GDP,retail credit levels are expected to be above one or more of the rules of thumb. By contrast, government credit hotspotsare projected for a much smaller set of countries, between them representing 13-14% of world GDP. At a regional level,however, Western Europe will remain vulnerable to unsustainable government borrowing: countries representing 31% ofthe regions GDP are expected to exceed one or more of the rules of thumb for government credit.

In wholesale credit, Asia is expected to be the main driver of hotspots in 2020, with countries representing more than halfof the regions GDP projected to be above a rule of thumb for wholesale borrowing. Western Europe also appears at riskof unsustainable credit levels in the wholesale segment.

in hotspots

by region

As discussed in the previous chapter, the rules of thumb are indicators that should spark a deeper investigation into thepotential for a particular segment to become a credit hotspot. Some countries and segments are better able to sustainhigh levels of credit than others. One determining factor is a countrys competitiveness. As Exhibit 19 suggests, morecompetitive countries are able to sustain larger ratios of credit to GDP, as competitiveness facilitates higher growth for thefuture. If highly indebted but less competitive countries are to improve their sustainability, they will need to increase theircompetitiveness or decrease leverage, or both.



Mechanisms to limit hotspots

Lessons from the past help identify mechanisms to address hotspots in the retail, wholesale and government sectors.Canadas resilience during the 2007-08 nancial crisis is an instructive case. Experts attribute this in part to the stablestructure of the banking system, which is dominated by ve large, heavily regulated banks that operate under very tightrisk controls. For example, the governor of the Bank of Canada ruled in 2008 that bank-owned mortgages would beeligible for insurance only if they had a loan-to-value ratio around or below 70%. As a consequence, banks were very

strict with their lending.

One key factor that drives unsustainable borrowing is a lack of nancial understanding among consumers (and oftenamong wholesale and government borrowers as well). According to a 2007 survey of US credit card holders, over half ofthe respondents said they had learned not too much or nothing at all about nance at school30. In Slovakia, a WorldBank report noted that many consumers borrowed from unregistered consumer credit companies at effective annualinterest rates of 120-229% when bank loans at a rate of 14% were available; while in Croatia, many co-signers of loansdid not realize they would be responsible for paying the debt of a friend or family member in the case of default31. Financialeducation by governments and nancial institutions is therefore a further intervention to mitigate against consumers takingon credit they are unable to repay.

The next chapter sets out specic recommendations for nancial institutions, regulators and policy-makers to detect andlimit future hotspots.

30 Niall Ferguson, The Ascent o Money: A Financial History o the World(Penguin, 2009)31 Rutledge, Susan. Consumer Protection and Financial Literacy: Lessons from Nine Country Studies, The World Bank, February 2010



What Is the Future Risk o Contagion?

Once hotspots have been ident

more credit with fewer crises 2011

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