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The academic literature and the popular press emphasize high levels of household debt as a threat to financial stability. Using Canadian data, we show that the household debt service ratio is a better predictor of financial distress than measures focused on debt ratios. We construct a new financial vulnerability barometer for the Canadian economy in which the debt service ratio improves its ability to predict periods of financial vulnerability. We also show that new borrowing, while increasing economic growth in the short run, leads to an increase in debt servicing which contributes to slumps in activity and to financial instability. Finally, we show that the debt service ratio also has significant out-of-sample predictive power for growth and financial crises.

Predicting financial crises: debt versus debt service ratios