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Third International Seminar on Early Warning and Business Cycle Indicators Moscow, 17-19 November 2010

Third International Seminar on Early Warning and Business Cycle Indicators Moscow, 17-19 November 2010. “Early warning indicators to predict financial crises” Gert Schnabel Monetary and Economic Department, Bank for International Settlements . 1.

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Third International Seminar on Early Warning and Business Cycle Indicators Moscow, 17-19 November 2010

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  1. Third International Seminar on Early Warning and Business Cycle Indicators Moscow, 17-19 November 2010 “Early warning indicators to predict financial crises” Gert Schnabel Monetary and Economic Department, Bank for International Settlements 1

  2. Early warning indicators in the context of BIS research • Special focus of the BIS: financial and monetary stability rather than cyclical stability • Policy orientation > - macroprudential policy (stability of the financial system) - monetary policy (price stability) • Special focus of the research on stability of the financial system: - credit and asset prices • Business cycle and financial cycle go together and interact but are no the same - credit cycles are typically longer

  3. Some BIS publications • Selection of important BIS research pieces (upon which the following is based) • http://www.bis.org/publ/work114.pdf?noframes=1 Borio, Lowe – Asset prices, financial and monetary stability: exploring the nexus (2002) • http://www.bis.org/publ/work157.htm Borio, Lowe – Securing sustainable price stability: should credit come back from the wilderness? (2004) • http://www.bis.org/publ/qtrpdf/r_qt0903e.pdf Borio, Drehmann – Assessing the risk of banking crises – revisited ( Quarterly review, Q1 2009)

  4. The early warning indicator concept (BIS) • …Drawing on Kaminsky/Reinhart (1999) methodology: working with noise/signal ratios and threshold values • … but deviating in various respects

  5. Specific features of the early warning indicator concept: • …working with cumulative changes (gaps) • … working with real-time data • … working with combination of indicators • … working with multiple horizons

  6. Which Indicators ? • …(private) credit/GDP and asset prices • … asset prices > build-up of bubbles • …(private credit)/GDP > absorption capacity/leverage of the private sector • … asset price candidates: equities, property prices, aggregate asset prices • … in real terms (to capture the excess inflationary development of assets)

  7. Gap concept: • deviation of credit/GDP respectively property prices from their trend • trend: one-sided HP-filter with a large lambda, ie very smooth trends as the target is to capture the gradual building up of imbalances • smooth trends are also justified by the fact that credit cycles tend to be rather long

  8. Real time data: • Trend calculation based on the data available at the period to which they refer, ie • - no later data revisions • - no adjustment of the trend based on data referring to future periods • Idea that at a specific point of time, assessments of potentially upcoming crisis must be taken on the then available information

  9. Combination of indicators • Signaling of crisis tested • … by combining indicators • … and by seeking to optimise the threshold values

  10. Multiple horizons: • … aim is to predict the occurrence of a crisis not the exact timing • … leading properties normally comparably long

  11. Noise signal ratio (NSR) • T1 (error type 1) : crisis occurred but was not predicted • T2 (error type 2): crisis was predicted but did not occur • NSR = T2 / 1 – T1 • Minimising NSR ? • Target function (ie threshold setting) depends on the weighting of T1 and T2 • Chosen: minimising under the condition that a minimum number of crises has been correctly predicted

  12. General results • Credit/GDP gap outperforms the other indicators • Multiple gaps outperform single indicators • Results are not extremely threshold sensitive • > policy recommendation: not considering the gaps and its thresholds as a strict rule but as guidelines

  13. Possible extensions • adding the external component - external exposure of banks - property prices in the exposure countries

  14. Use of indicators in the current discussion • Basel III discussion • Countercyclical buffer: recommendation to use the credit/GDP gap as guide for the buffer ….but not without judgment and.. • taking into account cross-border banking activities: weighted Credit/GDP gaps of the countries in which the banks operate

  15. Data needs • Domestic private credit in particular: long series on broad credit in harmonised definition • Asset pricesin particular: long series for property prices, especially for Emerging market economies • Cross – border banking data in particular long series

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